Egyptian Turmoil Bullish for Oil Stocks, But Not for Reasons Some Might Think

by: Kenneth D. Worth

Egypt is in turmoil. The price of crude oil is at post-2008 highs, at over $100 a barrel for Brent. Cause or indirect effect? What is going on?

Over the past decade, Egyptian crude oil production has fallen. Meanwhile domestic consumption has grown significantly.

Once an exporter of 500,000 barrels per day, Egypt now exports no oil at all. Additional oil supplies must come from abroad. Government oil revenues have plummeted to zero.

Consequently, governmental subsidies for food, energy, health care and other services have been cut, and additional cuts are being threatened. The people have taken to the streets demanding change. But a new regime won't solve Egypt's problems.

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Over the past decade, Egyptian oil production has fallen from a peak near 935,000 barrels of oil per day in 1996 to current levels around 685,000. Production has been consistently falling for 14 years and is not likely to increase any time soon, certainly not in this political climate. Egypt is very likely permanently past its peak production.

Meanwhile, the Egyptian population has surged to nearly 80 million, a 20% rise in the past decade alone.

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Many Egyptians are middle class, drive to work and benefit from gasoline subsidized by the government that is sold for $1.17 per gallon. Domestic crude oil consumption, however, has risen over the past decade to equal domestic production. Now there are shortages, because the government can't afford to import wholesale gasoline for $2.50 a gallon and sell it for $1.17 retail. Consequently, supplies are rationed, and Egyptians must wait in long lines to buy gas.

Worse yet, the Egyptian government has lost its revenues from oil exports. These revenues were formerly used to subsidize food for the 35,000,000 Egyptians living on about $2 per day. Food prices worldwide are rising, in part due to increased use of cropland to create biofuels. As a result, there is rioting in the streets of Cairo. But what does this all mean for the price of oil and for investments relating to that commodity?

It's all about "Net Exports." What has happened in Egypt is now happening in every remaining oil exporting country in the world, and there aren't that many of them left. Production is falling, and domestic consumption is rising.

Global net exports of crude oil have consequently been falling since 2005.

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(Source: Data EIA, See the article on the subject by George Lordos.)

A 2 million barrel per day (mbpd) decline in global net exports between 2004 to 2008, in the face of rising demand from importing nations including China, was enough to send the price of oil from $40 a barrel to $148. After 2008, the decline in net exports has steepened, but the gobal recession has thus far prevented another spike in oil prices by destroying sufficient demand in the developed world, i.e. by creating 10% unemployment in the U.S. and elsewhere.

As net exports continue to fall, China, a once again growing U.S., Europe and the other oil importing economies will necessarily bid up ever more scarce exports from fewer and fewer countries (Egypt no longer among them).

For investors, this means that the major oil companies (ETFs include XLE, IYE), oil service stocks (ETFs include OIH, PXJ, IEZ), and exploration and production stocks (ETFs include XOP, PXE, IEO) will significantly outperform the rest of the equities market, to put it mildly.

Also benefiting will be the oil and petroleum product ETF's: USO, OIL, USL, UGA, UHN and BNO. Of these, I prefer the products ETFs, UGA and UHN, as well as Brent Crude ((NYSEARCA:BNO)) for reasons discussed here.

Egypt is a symptom of a fundamental problem (net export decline) that will drive oil prices significantly higher. Understanding these fundamentals will allow a sophisticated investor to dramatically outperform the broader market in the weeks, months and years ahead while the world watches the turmoil in Egypt, watches the price of oil rise and wonders, "Why?"

It isn't the potential threat to the Suez Canal through which passes only a million or so barrels of crude oil a day and that cannot handle the VLCCs and ULCCs that transport most of the world's crude oil. The trip around the Cape of Good Hope to Europe only takes about 10 days.

It isn't the threat of violence spreading to other oil-exporting Arab nations. As long as net exports in these countries are positive and the government can subsidize food and fuel to their people, unrest should remain muted.

The real problem is that Egypt has now joined the long list of oil importing nations (along with former oil exporters Indonesia, China and the U.K.) Following in Egypt's footsteps over the next few years will be Malaysia and Mexico. Meanwhile, production in the remaining oil exporting nations overall remains stagnant, and consumption in those countries continues to rise. The stage has been set for a very prolonged bull market in oil stocks and significant price appreciation for the ETFs listed above.

Disclosure: I am long UGA, XLE, XOP, BNO.