Can Oil Go Even Higher?

In a recent article published in the CFA Institute Conference Proceedings Quarterly, Mohamed A El-Erian, CEO of PIMCO, states that traditional risk management is too heavily dependent on historical correlations and value-at-risk assessments. Today, a better approach is to focus on “tail insurance”, the left tail of the return distribution. In the meantime, investing has to be very focused on the few opportunities that have enormous reversion-to-the-mean elements.

This Friday, the price of oil held above $61 a barrel, helped by a weakening dollar. With the price off around 60% from its all time high, which was set last July at $147, could oil and gas be one such opportunity? I doubt about it. A deteriorating world economy, conservation and competition from other fuels would cut deeply into oil demand.

According to minutes of a Fed meeting released this past week, the Federal Reserve sees "significant downside risks" for the U.S. economy, with the global financial system still "vulnerable to further shocks".

In an April 2009 report, the International Energy Agency (IEA) predicted global demand for crude oil in 2009 would decline nearly 3 percent from the 2008 level of consumption. Such a contraction in demand would be the most severe since the early 1980s.

Without an economic recovery on the horizon, most likely, the price of oil would stay at the current $60s level. As of May 22, NYMEX crude oil future is $64.3 for Dec. 2009, which further confirms this price range.

In the early 1900s, cheap oil price – 3 cents a barrel – made it economical for railroad and steamship companies to convert from coal to oil. In 1941, America was the acknowledged king of oil-producing countries, pumping 63% of the world supply, according to The Big Rich, The Rise and Fall of the Greatest Texas Oil Fortunes, by Bryan Burrough.

Skyrocketing oil prices in the 1970s had forced the world to scramble for cheaper sources of energy, leading to a wholesale recovery of the coal industry and especially the nuclear power industry, both of which by 1980 emerged as prime competitors to oil. Oil’s share of worldwide energy use fell from 53% in 1978 to 42% in 1985. When the economy fully recovers this time, combined with “peak oil theory”, it might temperately push the oil price higher again. However, gradually matured alternative energy sources such as nuclear, wind and solar could decrease oil demand, just like they did in the 1980s. Among these alternatives, First Solar (FSLR) looks pretty interesting to me.

Even though oil might not go much higher, it is still worth to have it as part of your portfolio. In the August 2008 issue of Journal of Financial Economics, an article titled “Striking Oil: Another Puzzle” demonstrates that a rise in oil prices significantly lowers future stock returns, particularly for developed economies. In addition, with a potential plunge for the US dollar on the way this week and beyond, real asset class such as oil might be a “tail insurance”, in case the US government loses its AAA rating.

United States Oil (USO) and Energy Select Sector SPDR (XLE) are the most popular oil ETFs. USO invests in futures contracts for crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels. However, as you can see from the chart below, USO is more volatile than companies such as EnCana Corp. (ECA), Suncor Energy Inc. (SU) or Canadian Natural Resources (CNQ).

click to enlarge

In 2008 the oil and gas industry experienced an increase in certain costs that exceeded the general trend of inflation, which affected the industry’s operating expenses and capital programs. In 2009 this pressure has released quite a bit. That’s another reason I prefer oil companies to USO.

Canadian Natural Resources engages in the exploration, development, and production of crude oil and natural gas. 56% of revenue is from crude oil, and 44% is from natural gas. Cash flow remained strong in Q1/09, with $1.5 billion from operation. It also has available unused bank lines of $1.7billion as of March 31, 2009. The cash flow generated from operations, the flexibility of its capital expenditure programs, its existing credit facilities and its ability to raise new debt on commercially acceptable terms would provide sufficient liquidity.

The single biggest factor that affects the results of operations is movement in the price of crude oil. It could be potentially hedged away. However, one of threads to CNQ’s cash flow could also come from its commodity hedge. With a 2009-projected P/E of 14 and no significant upside potential due to hedging, I am wondering whether to replace it with Chevron Corp. (CVX), which has one of the strongest balance sheets among major oil/gas companies. CVX has $9.3 billion cash in hand and its debt is $12.2 billion.

Disclosure: I have a long position on CNQ

Comments

[PastTense:]

Most petroleum is used in automobiles. There are no fuel alternatives for them which have a significant market share. And in countries like China and India, the rapidly growing middle class want an automobile of their own. So it will be the developing economies which will have a rapidly increasing petroleum use. On the other hand peak oil has arrived and the world is going to be extracting the same or somewhat less petroleum every year.

So oil prices will keep going up (although in an erratic manner).

May 24 04:07 PM

[cameroni:]

If markets tank again by September we can expect oil prices to follow. In the meantime I would not be surprised one bit if oil hits 70 dollars by early fall, particularly as it is priced in US dollars. (How could it not go up given recent dollar events.....as Gold climbs so will oil).

Cam

May 24 06:55 PM

[Dirk McCoy:]

Can oil go even higher? Absolutely. Will oil go even higher? For sure. The only questions are when, how high, and with what kind of stability.

You are right that conservation and a weakened economy, as well as growing demand in the developing world, are important; those are already priced in. What's not priced in would be a war involving Iran, worsened supply degradation in Venzuela and Nigeria, or exposure of overstatement in reserves and/or capacity in Saudi Arabia. This could cause the price of oil to skyrocket, and the inability of automobile drivers to stop driving, even if spending an extra $200-300/month on gasoline, could keep prices high until alternatives emerged.

The good news is that there are lots of alternatives to $5/gasoline- but they will take a few years (and confidence that oil will stay at or above $80/barrel), so I ultimately think oil will settle around $80 over the longer term.

May 24 11:54 PM

[fairguy:]

to me, there are more things that make the oil price to higher than to go lower or flat from here.

May 25 01:40 AM

[one eye:]

I clicked on your chart trying to get an enlarged picture instead, It was smaller.

May 25 02:15 AM

[harammph:]

Every single one of those wavy lines on the chart above is moving UP.

Apparently, you believe they are going down. Don't use a chart next time.

May 25 02:56 AM

[Ferdinand E...:]

I don't think about a possible increase in the oil price any more, because it is impossible to judge the reasoning of the oil producers on that subject, but I definitely believe that the OPEC producers are rational enough not to allow the oil price to fall much lower than it is at the present time. Put another way, almost 40 years of playing ego games by individual producers has probably come to an end.

May 25 09:13 AM

[Road Runner:]

First, the world is not going to slip back into another recession soon because of the large US and China stimulus packages, and because the US Federal Reserve is pumping trillions of dollars into the economy. If anything, because of the natural 12 to 18 month delay in such stimulus hitting the economy, we will enter a phase of growth and strong inflation.

Also, the emerging economies like China and India have not stopped growing through this banking crisis. Their thirst for autos in huge and growing. Everybody wants the American lifestyle.

And finally, we have not reached peak oil but we have definitely reached peak cheap oil. There is massive amounts of oil in the Canadian oil sands and the Western US oil shale, but it is very expensive ($70/barrel plus) to extract. Add to that the constant pounding from the global warming camp who seem to have a strong influence right now. Note that I am not criticizing nor supporting this group, only pointing out their political influence.

Add the above 3 together gives a world that is totally different than the post oil-shock world of the late 1970s where oil became very cheap for 2 decades, the 80s and 90s. We are not going back to cheap oil. Oil has nowhere to go but up from here. My non-expert news-junky prediction is $70 oil by the end of 2009 and $100 oil by the end of 2010. That seems to be in line with the oil analysts I hear on the business channels, and what I read online.

$100 oil, and $3.40 gas, is enough to support a robust alternate energy industry. I know, the connection between the 2 is mostly physiological because solar is electric grid and oil is autos, but the connection is there. $100 also gives plenty of incentive to develop expensive oil production like oil sands. $100 may become the long term (like 30 years) baseline price for oil.

May 25 10:04 AM

[Charles Pet...:]

Crude can continue to rise as long as the government is purposely hammering the dollar. Each and every bailout that puts more potential public dollars on the line is a chance for oil to rally much higher.

If you think oil is going down from here (which it sounds like you do from your article) I would look into XOM as they will more than likely fall the least in a down energy market.

May 25 11:10 AM

[Bruce Pile:]

You can find several oil stocks where the oil price debacle has not even dented a rapidly climbing cash flow curve, making them much more attractive than USO or any pure play on oil price. Endeavor International (END) has ramped their per share revenue up 2400% since 2004 and their cash flow up over 600%! Maybe they want more oil debacles like this. The insiders were grabbing up shares with both hands during last year's panic. The stock, of course, is way down from its high, but now it is absurdly cheap with a current PE of about 4 and a phenomenal growth rate.

May 25 02:52 PM

[jayminho:]

oil will go up not because of us, acctually, forget us.
oil will go up due to the non stoping internal market developing of china, india and brazil, (probably some others, but those are the main players)

everything is now connected to china.
what they will do, what they wont.

will they dump their 2t ?
are they keep switching their 2t usd accumulated through decades to commodoties (like investment in petrobras and similars?)
what about their internal market ? infra structure ?
they move the world now.

May 25 05:37 PM

[MarkitWacha:]

Before you invest in XOM or any oil major, consider that they are susceptible to P/E multiples changing in the broader market. You can hedge out this risk by shorting the market at the same time as buying an oil company stock, or buy purchasing futures contracts for oil.

I prefer the GSG ETF for this reason.

May 25 09:35 PM

[Mistrofan:]

Bravo Hao - well said.

May 25 10:26 PM

[whisperonth...:]

Maybe it was the Firefox browser, but clicking on your chart made it smaller. Useless.

May 25 10:41 PM

[Fighting Yoda:]

Why should oil price go higher when demand is falling, inventories keep rising. Whenever anyone presents a bullish case for oil they take it for granted that demand for oil will keep rising and production will keep falling, when facts are quite to the contrary.

As per latest figures, since last October when OPEC announced production cuts, inventory has risen - from 57 mi brl. to 100 mi brl. , floating cargo about 62/63 days supply from 52 day supply.

The recent oil price rise has been due to 2 reasons - OPEC production cuts, and market speculation (green shoots and such stupidity), and China bottom fishing - all short term phenomena - noting at all to do with any long term demand/supply. Based on such data and making a long term case is nothing but foolishness. All such foolish made oil go to $147, just to crash to $32 in 6 very short months.

May 25 10:43 PM

[Charles Pet...:]

Oil can go as high as as the dollar far, and thats before fundamentals even kick in, so the answer to your question is as high as the Federal Reserve lets it.

May 31 06:27 PM

[Living4Divi...:]

Higher oil prices are caused by:
1. A Weak U.S. dollar: oil is a global commodity, but it is priced in a local currency (the Dollar)
2. Supply: OPEC's production quotas and the inventory of crude oil
3. Demand: The pace of the global recovery.
4. Speculation and Hoarding

Recently folks were worried that oil would drop below $45/bbl and stay there. Why were they worried? They should have been praying for such a miracle. Oil used to be over $147/bbl not too long ago, so it can get expensive. There is alot more upside potential than downside potential to oil. After all there is only so much of it in the ground.

Jun 05 08:27 AM