The Economies Of Oil And How To Profit

by: Holmes Osborne

There is a common misperception regarding oil for the average American. This misperception is that because of horizontal fracturing, the price of oil will come down. Nothing could be further from the truth.

The misperception is that everything is great. We have reversed the trend. We are in an era of cheap oil. Wrong. The Department of Energy is guessing that West Texas Intermediate Crude will average in the $80s per barrel to the low $100s for the next few years and that prediction could very well be off.

The Metrics of Oil

It is true that we are finding more oil and the downward trend has been reversed. According to the latest information in October of 2013 from the Energy Information Association, the U.S. produced 7.753 million barrels per day and had net imports of 7.4 million. I am using the metric of barrels per day and quoting the EIA in this report. In 1972, our oil production peaked at 9.441 million barrels per day. At its nadir, we produced 5 million per day in 2008. The great M. King Hubbert of Royal Dutch Shell (NYSE:RDS.A) predicted peak oil in his famous report from 1958.

The countries with the largest share of net U.S. importers are the following: Canada (34%), Saudi Arabia (18%), Venezuela (12%), Russia (10%), and Mexico (6%). Our share of OPEC oil dropped from 5.4 million per day in 2007 to 4 million in 2012.

But this all changed in 2009 when we produced 5.5353 million per day. Of course this was due to the discovery of horizontal fracturing by George Mitchell of Mitchell Energy. Mitchell Energy was subsequently bought out by Devon Energy (NYSE:DVN).

The U.S. has laws on the books that limit crude exportation. Enacted in 1975, the Energy Policy Conservation Act not only governed exports but also set up the Strategic Petroleum Reserve and Corporate Average Fuel Economy. To quote straight from the law, "The President shall exercise the authority provided…. to promulgate a rule prohibiting the export of crude oil and natural gas produced in the United States, except that the President may… exempt from such prohibition such crude oil or natural gas exports which he determines to be consistent with the national interest and the purposes of this Act."

According to a recent article in the Wall Street Journal, refiners are split on the issue. Valero (NYSE:VLO) is against the issue while Marathon (NYSE:MPC) and Tesoro (NYSE:TSO) are for it.

It's a controversial issue, but personally, I'm for increasing exports. Why? It may indeed push up the price of oil for Americans, but we need to get off the stuff and this may help. Plus, in a free market, caps like this distort the economy and thwart innovation.

Oil is Fungible

What Americans are not focusing on is the rest of the world, especially emerging markets. India consumed 643,000 barrels per day in 1980 and 3.6 million in 2012. China used 1.7 million in 1980 and 10.3 million in 2012. The entire world consumed 63 million in 1980 and just a touch below 89 million in 2012. Global population is 7.1 billion and the U.S. only has a population of 314 million.

Oil is fungible. That means that the refined product is the same as what is produced in oil wells in the middle of Beverly Hills, California, (in part owned by Freeport-McMoRan (NYSE:FCX)) is the same as what is produced in the middle of Iran. There may be varying levels of sulfur, may come from miles beneath the surface of the ocean, or may have to be dug up in Canada, but it all ends up as the same product. Of course most oil is used in transportation but some paves our streets.

So that consumer filling up his BMW across the street from the oil well that sits on the campus of Beverly Hills High School is competing against the cab driver in Tehran for the same product. Why? Because there is close to a 100% correlation in the price of oil across the globe. Sure, West Texas Intermediate crude may be $91 and Brent $107, but if an analyst looked at the historic correlation as measured by R squared between the two, it would darn near be perfect. We all drink from the same cup.

Africa's wealthiest man, Aliko Dangote, recently announced that he was building a $9 billion refinery in Nigeria. It is reported that the facility will refine 400,000 barrels of oil per day. That is oil that will most certainly get used by Africans to satiate their need for petroleum. Again, further proof of emerging markets competing for global oil.


Another reason for higher prices is inflation. According to the St. Louis branch of the Federal Reserve, M2 in 1980 was $1.6 trillion. M2 is a measurement of cash, money market, savings accounts, and other money in the U.S. economy. At the end of 2013, it was almost $13 trillion. Our population in 1980 was 226 million and has grown by almost 40%. So our population has grown by 40% and our money supply has grown by 712%. Can you say inflation? More money chasing fewer goods.

Peak Oil

So what is the future for oil? Almost certainly higher prices. The theory of Peak Oil is not done. It just pushed the theory out a few years. All oil wells eventually run dry. Oil sands are dug up. Frac wells get exhausted. It's just that higher prices beget more discoveries because the discoveries become economically feasible. At $90 a barrel, North Dakota is hopping. At $30 a barrel, turn off the lights if you're the last person leaving.

What about alternatives such as natural gas and electric automobiles? It's a possibility. Let's hope it happens. Evidentially, the market does not have much faith in this or oil would be $30 a barrel lower and natural gas would be a couple of dollar per million British thermal units higher. The market wants to see more evidence and does not believe in the hype.

Don't get me wrong. Oil is dirty, contributes to Global Warming, and comes from many places that don't like Americans. If we're smart, we'll get away from it as fast as possible. Natural gas, electric gas, solar, wind, anything but oil. The present level of carbon dioxide in the air is at its highest in the past 800,000 years. But as an investor, it makes money.

How to profit

How do you make money investing in oil? By being patient. It will take a decade before you make a lot of money in the usual energy companies.

Some of my favorites have had problems. As a value guy, I like sifting through the heap and waiting for a turnaround.

You can invest in vertically integrated majors like BP (NYSE:BP). BP is involved in everything from finding it to pumping it into your car. Plus, it has a 4.7% dividend while you wait. If you held it for five years, you'd be up 25% in dividends alone.

My favorite oil sand is Imperial (NYSEMKT:IMO). Imperial has a AAA bond rating and is 71% owned by Exxon (NYSE:XOM). Imperial estimates that it will produce one million barrels per day in 2030 and is currently producing 282 thousand of barrels per oil equivalent according to the last annual report. Imperial is not an exciting company but should do well as a long-term hold.

Weatherford International (NYSE:WFT) provides the parts for drillers to find the product. The company had some accounting issues, but it looks as though these problems are behind them. At 1.4 times sales, the stock is not expensive.

How about deepwater oil? Transocean (NYSE:RIG) can get to depths that most can't reach. If you are one of the majors, you are likely to contract one of Transocean's rigs. And again, it has a 4.6% dividend so you are being paid to wait.

Like any portfolio of commodity producers, petroleum is cyclical. If you are patient, a portfolio of these stocks should outperform if you can stand the downturns.

Disclosure: I am long IMO, BP, WFT, RIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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