Ideas for Hedging Against the Possibility of $220 Oil

by: Michael Bryant

A few days ago I got an email saying oil could go to $220. It was just a promotional email about a stock newsletter. But I wanted to investigate this theory.

A quick Google search gave “Nomura Predicts $220 Oil If Just Libya, Algeria Cut Output.” Well, Libyan output is likely gone, especially with Gadhafi’s recent violation of a cease fire. International forces have already launched military attacks on his forces. About Algeria, the current situation does not seem threatening, but it could turn out to be just as bad as the Libya crisis.

Some of the key aspects Nomura points out is that the current crisis in the Middle East and North Africa is similar to that of the 1991 Gulf War. If Libya and Algeria shut down, then 2.1 million barrels/day will be lost, similar to the 1.8 million barrels/day lost during the Gulf War, when prices surged 130%. Interestingly, Nomura also points out Wikileaks' claim that Saudi Arabia is massively overstating its reserves.

If you take $80 a barrel as a normal price, 130% higher would be $184 a barrel. If you take $100 a barrel as a normal price, 130% higher is $230 a barrel. Either way, oil seems to be heading higher.

But even if Algeria stays fine, what about Bahrain and Yemen? Saudi Arabia has its own problems with rebels, too. And do we really need to lose Algeria? Production figures in 2009 for Algeria, Libya, Bahrain, Yemen, and Saudi Arabia were 2.125, 1.790, 0.0485, 0.288, and 9.764 million barrels a day, respectively. Thus, just by losing Libya, we are already close to the 1.8 million barrels/day lost during the Gulf War. Add Bahrain and it is even closer. Plus, Iran said that it is against any output increase.

With Libya now effectively in a state of full-scale civil war and production down to a trickle, other OPEC countries may need to further ramp up production in the weeks and months ahead to offset lost output of 1.5 to 1.6 million barrels a day,

the IEA said. But that might not happen, since Iran seems strongly against it. Plus, OPEC has already increased production in the month of February. How much more can those countries increase production, and do they really want to increase them?

And do not forget Nigeria, which has been in conflict for a long time and reported a 3.8% decline in oil production in February.

Oil picks

As oil is likely to rise, I stand by my old picks: Atlas Pipeline (AHD), Delta Petroleum (DPTR), First Majestic Silver (NYSE:AG), Great Panther Silver (NYSEMKT:GPL), and Royale Energy (NASDAQ:ROYL) from my $140 oil article. These stocks will likely perform the best if oil rises. As for Toyota (NYSE:TM), the current tsunami in Japan has crippled the stock, and it now seems a buy not on oil but as a value play. On Chemical & Mining Company of Chile (NYSE:SQM); lithium will be in very high demand if oil soars.

Two additional picks I would recommend are Samson Oil & Gas (NYSEMKT:SSN) and Kodiak Oil (NYSE:KOG). Both have significant interest in the Bakken Shale in the U.S. and seem poised to jump if oil surges.

Other plays I would recommend are oil services. As oil rises or falls (it will be volatile as news of the Middle East and North Africa situation come out) companies that provide services to oil producers will still be in high demand.

In the segment, deepwater drilling has been a hot area. Transocean (NYSE:RIG) is the dominant player. The stock has been hit hard by the BP (NYSE:BP) oil spill, but has since steadily recovered. The price is still below its pre-BP oil spill price, so it still seems undervalued from that perspective. Dryships (NASDAQ:DRYS) is an interesting play since it is mainly a drybulk shipper, but it also owns Ocean Rig, an operator of deepwater drillships. In an earlier article, I claimed that the drillships unit is worth $2-2.5 billion, much higher than the company’s $1.4 billion market cap.

Lastly, Hercules Offshore (NASDAQ:HERO) looks the best value-wise. This is more a duel deepwater and shallow-water drilling company. The company sold its unit, Pride International, for $7.3 billion. It still has not sold its Seahawk unit. At a current market cap of $632 million, shares look greatly undervalued.

And you can’t forget railroads, Warren Buffett’s favorite picks over the last few years. His top holdings includes Union Pacific (NYSE:UNP) and Norfolk Southern (NYSE:NSC), two of the nation’s largest railroads. His company, Berkshire Hathaway (NYSE:BRK.A) even bought Burlington Northern Santa Fe, which has turned out to be a very profitable move. The idea is that railroads are a more energy efficient way to transport goods than by truck.

Disclosure: I am long SSN, DRYS.