Oil: Black Gold, Texas Tea.
We could make a fortune if we knew for sure what the price of oil was going to do and the time frame it was going to do it in. Many fortunes have certainly come about from finding, drilling, refining and delivering the stuff.
The only thing we really know for sure is that oil is what fuels the economy of the West, and more and more the East, and that all of the easy to get, high grade stuff has been gotten.
I was in the oil business for 10 years a few decades ago, back at the end of the era of “big oil”. So I have a keen interest in the gooey black stuff, and watch the price of oil fairly closely. But when it comes to investing in oil stocks and oil exploration stocks, I rely on the experts at Casey Research through their excellent investment newsletters on the topic.
Here is an essay from Joe Hung, one of Casey Research’s oil researchers.
Oil: Short-Term Bear, Long-Term Bull
By Joe Hung
On October 21, 2009, oil broke US$80/bbl for the first time this year, more than double from the February low around the US$35 mark. Here at Casey’s Energy Confidential, Casey’s Energy Report, and Casey’s Energy Opportunities, we are frequently asked for our outlook on the price of oil.
Our response typically is this: we are short-term bears on oil and believe in a general market retreat to knock the price of the commodity back down, yet we are long-term bulls due to the fact that we believe the supply of cheap oil is running out.
These two views are definitely not contradictory. In fact, if we are correct (and we have every reason to believe that we are), our subscribers will be able to grab the chance of a lifetime when the price of oil dips down once again and ride the upside that is inevitably to come. So first let’s look at our rationale for being a short-term bear on oil:
1. Short-term equity markets
During a panic, as we saw in the past year, all the boats in the water sink, not just the leaky ones. Quality companies were trading below the cash they held in hand, and people were selling indiscriminately. We do expect that the “second dip” of the recession is coming soon, and at that time, commodities such as oil that are intently tied with the industry of developed countries will fall hard. As people reduce their risk appetite in the short run during this panic, the U.S. dollar might have a short-term bounce, which will again drive down the price of commodities that are denominated in U.S. dollars, such as oil.
2. Near-term fundamentals
Looking at the OECD data from June, we see that production is at 2007 levels, but consumption is down by 7.2% when we compare June 2007 to June 2009. Inventories are also up by 200 million barrels since then. When we focus on the United States, the numbers become more apparent. In July of 2009, the U.S. consumed just 581.9 million barrels, 9.5% less than 2007. In fact, the last time the U.S. consumed so little oil in the month of July was back to 1997! Inventories, though much lower than in the months of April and May, are still much higher than their 5-year average. Clearly, in the short term, we should see a retreat at least 10% below 2007 levels, which would peg oil at US$65 within the next year.
Now let us look at why we think oil will take off after this drop:
1. Diminishing supply of cheap oil
Unfortunately for the gas-guzzling world that we live in today, the days of oil gushing out of the ground hundreds of feet into the air are over. Today’s oil is getting harder and harder to extract, as most of the easily pinpointed and extracted oil has already been taken advantage of. The best deposits are now generally now either locked in offshore waters (Gulf of Mexico, Brazil, West Africa), or in politically unstable regions (Libya, Iran, Iraq). Oil sands are another huge reserve, but they can be expensive to extract (at least $30 a barrel). This means as we use more and more oil, oil prices will be rising due to the increase in costs that are involved.
2. The long-term depreciation of the U.S. dollar
At the present, oil is denominated in the U.S. currency. This situation could last for quite a while until the other countries of the world agree to have it changed. This means if the Federal Reserve continues with its expansionary monetary policies, oil will continue to rise.
3. The emergence of developing countries
Right now, the OECD (Organisation for Economic Co-Operation and Development), the collection of most of the developed nations in the world, account for about half the oil consumption in the world. This number will decrease as countries like China and India begin to raise their standards of living, thereby increasing the amount of oil consumed by their denizens. This can only be an upward, not a downward pressure on the price of oil, especially combined with No. 1 summarized above.
So the conclusion is that though we view oil as a go-to commodity to watch for in the future, in the short term it is very vulnerable to pullbacks in the overall equity markets. We thus have cautioned for conservatism in our energy letters, and use US$40 as the basis for our analyses. If a company cannot be profitable at US$40/bbl oil, it will underperform its peers even when oil is higher. This next drop in the price of oil may be the best time to load up on high-quality oil explorers and producers, and putting money in this sector could be one of the best decisions in your investment career.
Chris again. Thanks Joe, very interesting stuff.
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However you decide to approach the energy markets, the key point is to make them a part of your overall portfolio planning. That’s because, regardless of everything else that’s going on in the world, people and businesses need energy… and therein lies the opportunity.