How to Position Your Portfolio for the Impending Global Energy Crisis

by: Logan Smyth

For the past month or two I have been researching and organizing my thoughts on what I believe is an impending global energy crisis. Until recently, I had been unable to fully convince myself that this was likely to happen. However, the recent events in the Middle East and Northern Africa have helped to embolden my concerns. As a disclaimer, I am not an expert and I am limited in my access to information. Having said that, though, I believe this is a very rational concern and is supported by widely available data.

My belief that a global energy crisis is impeding centers on the concept of peak oil. This is a topic that has been debated for decades but has recently gained credibility because of the IEA’s acknowledgement of peak oil as a reality. In its 2010 World Energy Outlook report, the IEA states

Crude oil output reaches an undulating plateau of around 68-69 mb/d by 2020, but never regains its all time peak of 70 mb/d reached in 2006, while production of natural gas liquids (NGLs) and unconventional oil grows strongly.

In other words, global production of crude oil actually peaked 5 years ago in 2006.

The IEA forecasts that total oil production will continue to grow at reasonable pace, though this growth is driven by natural gas liquids (NGLs) and “unconventional oil”, such as oil shale and tar sands. Perhaps the best way to understand the IEA’s outlook is with the graph below. Be sure to notice that much of the stability of crude oil production is predicated on “oil fields yet to be found” and “oil fields yet to be developed”. I may be skeptical, but I find it all too convenient that these assumptions provide a steady level of crude oil production, especially given the precipitous decline in production from current oil fields.

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My concerns on peak oil are really nothing new. The World Energy Outlook report I cite was actually released three months ago. However, my fear is that the fundamental economic issues presented by peak oil, coupled with growing demand for energy as a result of the improving global economy, will be compounded by the events unfolding across Northern Africa and the Middle East. I’m sure there are a whole host of opinions on these events, but to me it looks as if the region is rapidly destabilizing.

In the past couple months there have been anti-government protests in 15 Arab countries, with some turning violent. Egypt’s government has already been overthrown and Libya’s government is currently waging war against its uprising citizens. Also concerning is Iran’s plan to move two naval vessels through the Suez Canal on Tuesday. This would place the ships very close to Israel’s coastline and is rightfully being seen as an act of provocation by the Israeli people.

Suffice to say, the region appears to be getting more unstable each day and these anti-government movements appear to be gaining momentum. Further, there is no reason to believe that these power struggles will be resolved quickly. Even if oppressive governments are overthrown, it will take quite some time to establish new governments. There is also the possibility that multiple groups will fight for power in the absence of a formal government, something that is plausible in Libya if Muammar Gaddafi is overthrown. Any prolonged instability in the region could have a profound impact on the price of crude oil, especially if it begins to create supply disruptions.

The key areas to watch as this unrest continues to unfold will be Iran and Saudi Arabia. These two countries sit on a combined 418 billion barrels of oil reserves, 10 times the amount of oil reserves in Libya. The news out of Libya on Monday was enough to push crude higher better than 8%. If political unrest gains traction in Saudi Arabia or a conflict develops between Iran and Israel, the move in crude prices would dwarf Monday’s action. Of these two scenarios, though, the latter unfortunately looks more likely.

Technical analysis

From a technical analysis standpoint, if short-term catalysts are able to push Nymex crude futures over $100/barrel, the continued upside could be substantial. Crude oil has only been above $100/barrel once before, so above that price level there is little historical resistance. Further, the last time crude broke the $100 level, it skyrocketed almost 50% to $147/barrel. Also, it is interesting to note the last time crude broke above $100/barrel was in February of 2008 and it reached $147 by July of that year. I will be watching the $100 price level very closely and I think a break to the upside signals a significant move higher.

My thesis is based on a few key assumptions that I have already outlined – global crude oil production has already peaked, the global economy will continue to grow driving increased demand for energy, geopolitical risk in oil exporting countries could create supply disruptions, and a break of the key technical resistance level could fuel speculation of higher oil prices. If I am correct in my assumptions, I think there are many different ways investors can position themselves.

How to play it

First, the most obvious pure-play on higher crude prices would be Nymex crude futures. I have not purchased any futures yet, but I am looking at expirations between August and December of this year. Based on the pullback in crude prices following Hosni Mubarak’s resignation, it is possible we might see a similar pullback if Muammar Gaddafi is removed from power. This pullback would provide a good entry point with the expectation that unrest in the region will continue in the short-term.

My favorite investment idea is a long-term play that I think has tremendous growth potential. Metabolix (NASDAQ:MBLX) is a bioscience company that has developed extremely versatile bioplastics that are just coming to market. It is also developing biofuels and alternatives to petroleum-based chemicals. The company has a broad patent portfolio and a manufacturing facility that can be expanded to four times its current capacity. Since industrial uses, like the manufacture of plastics, accounts for 24% of U.S. petroleum consumption, this company could see tremendous growth if we experience high crude prices for a sustained period of time. I should note that this company is still in its infancy and is just beginning to ship product to customers, but I think the long-term growth potential here warrants investor interest. Also, anyone considering investing in this company should do some further research as it is not yet profitable and carries additional risks.

I personally am positioning myself using crude futures and Metabolix, but there are other investment ideas that would perform well too. Another interesting opportunity would be investing in Russia through the use of Russian ETFs. As the world’s largest oil exporting country, the Russian economy is driven largely by the price of oil. Also, solar energy companies like First Solar (NASDAQ:FSLR) should perform well with oil above $100.

I would avoid using oil ETFs as a trading vehicle, though, because they rarely return the same as the underlying asset. Similarly, I would be selective in purchasing individual oil companies. Many of the large integrated oil companies are already trading at their highs and are susceptible to government interference. It was only a few years ago that the government was considering a windfall profit tax for oil companies and blaming them for high gas prices. One attractive idea would be Suncor Energy (NYSE:SU) because it is insulated from geopolitical risk, it isn’t under the thumb of the U.S. government, and it would be able to capitalize on unmet U.S. demand.

As I wrap up, there are a few things I think are worth noting. First, it is important to remember that oil is a finite resource. Each day we have less and less, yet we use more and more. This paradigm is only sustainable for so long and according to the concept of peak oil, that tipping point was 4-5 years ago. Because of the economic impact of the financial crisis, global demand for energy was tampered significantly. Rest assured though that this effect was only temporary. As the global economy continues to recover, the demand for energy will continue to rise.

Finally, short-term investments like crude futures will perform well as global demand overcomes supply. However, the best performing investments will be in companies that provide reasonable, sustainable alternatives to petroleum and products derived from petroleum. Companies that will perform well in this regard will likely have patented proprietary technology, large addressable markets, and the ability to bring products to market quickly. As always, in depth research will be instrumental in identifying companies that will benefit from the shift to petroleum alternatives.

Disclosure: I am long MBLX.

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