Why Oil Prices Will Remain Sky High: It's All About Supply

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 |  Includes: HELX, OIH, SSL, STO, USO
by: William Trent, CFA

Oil was down yesterday on stronger-than-expected gasoline inventories, and let’s face it, the strong price run for energy and energy stocks over the last several years has many predicting (for the umpteenth time) there will be a correction (eventually they will be right). Business Week outlines the case for $50 oil. CNN Money agrees, saying:

Most analysts don’t expect oil to fall too much further in the short term, as demand remains strong and uncertainty surrounds supplies from Iran, Nigeria and Venezuela.

But the recent record-high prices have fueled a boom in exploration. And as that boom begins to yield more oil, the industry will gain a greater ability to ramp up production in one place in order to make up for any shortfall elsewhere.

And according to the latest Value Line Investment Survey:

The Oilfield Services/Equipment sector continues to be among the top-performing industries in the Value Line universe. The sector holds a Timeliness ranking of 4 out of a total of 97 industries. Many oilfield services companies are generating record results, thanks to a very tight drilling market. The robust operating environment is being driven by increased energy demand worldwide, combined with high oil and natural gas prices. This, in turn, has prompted major energy firms and independent exploration and production (E&P) companies alike to boost their capital spending on oilfield services and related drilling activity in order to pump more fossil fuels out of the ground.

Many stocks, however, have appreciated so sharply over the past few years (despite a recent retreat) that we question their attractiveness for capital gains potential out to 2009-2011. Nonetheless, we are in the midst of an extended up-cycle in drilling activity that has shown few, if any, signs of slowing. We believe the progress will continue at least through yearend, and probably well into 2007. Investors should have in mind, though, the historically volatile nature of the industry and its direct tie-in to the direction of oil and natural gas prices.

I have seen several people say “everyone is expecting oil to keep going up, so it probably will go down.” Somehow, the above quotes don’t look to me like everyone jumping on the oil bandwagon. Meanwhile, we think the knee-jerk reaction to yesterday’s inventory data was short-sighted for several reasons:

1. The higher-than-expected increase in stocks applied mainly to gasoline. Not petroleum products as a whole. The nature of refining could cause more or less of any given product to be produced any given week.

2. Part of the reason for the increase was that refining capacity utilization was higher than expected. Higher refining throughput should mean less crude oil and more refined products at the end of the week. So? It’s not like it all isn’t going to be refined eventually. Besides, the utilization rate of about 92 percent is quite high - what’s going to happen to prices if we use up the remaining capacity? Given how long it takes to approve and build new refineries that seems like a distinct possibility.

3. Who cares about what the estimate was anyway? Who is making the estimate and has anyone looked at how accurate these estimates have been in the past? The market supply/demand balance and the trend in that balance is far more important than what a bunch of prognosticators think the ending inventory will be in any given week.

4. Finally, that balance isn’t looking so hot. By our preferred measure of total petroleum product supplied relative to non-strategic reserve inventories, stocks are tight and getting tighter. As the accompanying chart demonstrates, this week’s reading of 49.5 days of inventory is down sharply from 50.2 days last week and appears to be confirming the long-term trendline of ever-declining days supply of inventory.

Days Inventory chart:

oil inventory

Although our Watch List underweights the energy sector vs. the S&P 500, this is partly due to the fact that our methodology tends to favor stocks with smaller market capitalizations. Furthermore, although only 5% of the Watch List is classified as being in the energy sector, another 2% are energy-intensive names in other sectors (Sasol (NYSE:SSL), a chemical company, produces fuel from coal and conglomerate Norsk Hydro (NHY) derives much of its revenue from oil.) This brings the total weight closer to the S%P’s 9%.

It also brings up another important point, which is that energy stocks are not the only way to gain exposure to energy prices. There are of course exchange-traded funds such as the Oil Service HOLDRs ETF (NYSEARCA:OIH), as well as many funds specializing in emerging markets that have high exposure to energy.

Russia’s rapid economic growth has been fueled by record high world prices for the nation’s booming oil exports.

Finally, as oil prices remain high, interest continues to rise in alternative energy sources.

In Upington, a town in the arid, ironed-flat expanse of the Northern Cape, the extreme and persistent heat may cause some to become hot and bothered, but to Eskom it’s good news - because this is where the utility is considering building its electricity-from-the-sun project. (In fact, the Northern Cape every year records some of the highest aggregates of sunny days a year worldwide.)

If Eskom takes the decision to go ahead with the project, it will be the first major solar-energy project in Africa, especially where the electricity generated will be directed into the main power grid of a country.

Plus, Watch List member Sasol Ltd., the world’s biggest producer of motor fuel from coal, is in talks with Iran’s government over the construction of a gas-to-liquid fuel plant, South Africa’s foreign minister said.

However, even alternative energy is subject to red tape, NIMBYism and environmental concerns as the below article highlights:

The first utility-grade wind farm proposed in Virginia is hailed by its supporters as clean energy that can help stem global warming and rising fuel prices. But mountaintop residents near the Highland County site worry about what the blades of 18 towers taller than the Statue of Liberty would do to their environment.

That would include rare or endangered birds, bats and a few other species, as well as a wild trout stream.

Eleven state agencies have reviewed the Highland New Wind Development proposal and come up with a lengthy list of suggested studies, including an analysis of the cumulative impact of wind farms on the four-state Allegheny Mountain region.

The State Corporation Commission, which has final say, will conduct a public hearing Oct. 30 in Richmond on the proposal by retired poultry processor Henry McBride of Harrisonburg. His attorney, John Flora, hopes the project can benefit from a federal tax credit that expires in 2007.

Year after year we have pundits telling us that oil prices will fall once the premium related to Prudhoe Bay/Iraq/Hurricanes/Whatever dissipates. We say oil will keep rising until long-term supply exceeds demand. Watch List member Helix Energy (HELX) just bought some facilities idled by last year’s hurricanes, and doesn’t expect them to come back on line until 2008.

Furthermore, increased exploration is no guarantee that projects will come on line. Another Watch List member, Statoil (NYSE:STO) proved some resources way back in 1989, but doesn’t expect them to become profitable until 2010.

The company said it and the other license holders aim to send the plan for development and operation to the Ministry of Petroleum and Energy during the autumn. A final cost estimate will also be available by then, it said. The Gjoa field is located 70 km north of the Troll field and some 45 km off the coast of western Norway.

Located in blocks 35/9 and 36/7, Gjoa was proven in 1989 but Statoil said making the project profitable has been demanding.

So let the pundits pundit. Our bets are on continued supply shortfalls.