We are currently living in an investment environment characterized by high levels of uncertainty coupled with high levels of speculation. In such a period, different asset classes might witness extreme price action, which is not justified by their fundamentals.
Just take the example of Crude Oil. From October 2007 (when the Fed started cutting interest rates), crude made a strong rally and almost doubled to $147 per barrel by July 2008. The Lehmann collapse and the subsequent credit freeze saw crude crashing all the way down to $33 per barrel in a matter of few months. Subsequently, as the economy stabilized from a free-fall, crude trended higher again touching a high of $115 per barrel. Since then, with indications of weakness in economic activity and a flurry of other bad news, crude has corrected again by over 25% (trading at $83 per barrel currently).
While fundamental factors did play a role in the price movement for crude, one can say with conviction that $150 was not justified by fundamentals, nor was $33 per barrel. It was speculation and a complete credit freeze that led to these price extremes.
However, in the long-term, crude, like any other asset class, will trend in the direction justified by its fundamentals. From this perspective, long-term investors can consider exposure to crude on any significant correction.
This article discusses the factors that support the long-term upside trend for crude oil. Before turning to these factors, I will note that investors can avoid considering exposure to crude
until more clarity emerges on the economic front.
The Demand-Supply Scenario
Back in 1964, the world added 48 billion barrels of oil in proven reserves every year with annual consumption only at 12 billion barrels. Currently, the world adds 5-6 billion barrels of proven oil reserves every year, with annual consumption at 30 billion barrels.
Simple calculations would tell us that the amount of available proven reserves is going down every year. Therefore, purely from the point of view of fundamentals, crude should trend up in the long term unless the world again starts finding gigantic oil reserves.
Another factor that makes me believe that crude oil consumption will be more than 30 billion barrels per year, going forward is the fact that in the United States, per capita consumption of oil peaked out at 27 barrels per year. In Japan, per capita oil consumption peaked out at 17 barrels per year. Compared with these developed countries, per capita consumption of crude oil is 1.8 barrels per year in China and 0.8 barrels per year in India.
Further, the same low consumption pattern is observed in Asia (ex. Japan), which is home to more than 3.6 billion people (56% of the world’s population). I am not suggesting that per capita consumption of oil in Asian countries will reach anywhere near the developed world in the next 10-20 years. However, due to the huge impending growth potential, even if per capita crude consumption doubles from current levels in China and India, it would be more than sufficient to trigger significant price upside arising from robust demand.
Therefore, from a demand-supply perspective, it looks highly likely that higher oil prices will result from a significant increase in demand from emerging Asia. Clearly, there will not be a scenario where OPEC is struggling to meet the demand. The key factor would be how much proven reserves the world adds and how much oil is consumed annually.
However, it is not just this rationale that makes me bullish on oil prices for the long term.
Deprecation of Dollar and other currencies
Very similar to gold, crude is a hard asset, whose supply can’t be increased at the pace of paper money. There is also no doubt in my mind that interest rates would remain low in the developed world for a prolonged period and the government would resort to further quantitative easing in order to keep the economy afloat.
With this in mind, crude would be a good long-term investment as it can be an effective hedge against a deprecating dollar. In other words, crude will not only trend higher due to demand. Crude will also trend higher due to debasement of paper money.
In my opinion, geopolitical tensions are another major factor, which will support increasing crude oil prices. There is high level of civil unrest in the Middle-East. Further, the probability of military conflict in Iran remains high. Iran happens to be the fourth largest producer and exporter of oil. Iran can easily block the Strait of Hormuz (through which 40% of the world oil shipment passes daily). Additionally, it is not just tensions in the Middle-East but the gradual shift of power from the developed world to the emerging economies that suggests global tensions will remain high.
All these factors combined make crude an excellent long-term buy. Volatility and fluctuations in the short term can be considered to increase exposure to crude.
I would personally be looking at exposure to a crude oil ETF coupled with exposure to exploration companies in relatively conflict-free zones. Most importantly, things are murky now in terms of economic outlook and the position of several banks in Europe. I would wait for more clarity to consider long-term exposure to crude at more attractive levels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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