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Venezuelan President Hugo Chavez said a few months ago that if the United States invades Iran, we could expect to see oil at $200 a barrel. With oil already approaching the $120 mark, we may get there even without invading Iran.

[Perhaps President Chavez could be tempted out of his chaos-causing rule in Caracas with the offer of a rich and perk-filled oil-analyst’s job at Goldman Sachs Group Inc. (NYSE:GS)].

My colleague - Money Morning Investment Director Keith Fitzgerald - agrees with Chavez that oil prices are headed much higher: In fact, since back in December, when crude oil was trading at $90, Fitz-Gerald has been predicting that petroleum prices would reach $187 a barrel. And there’s growing support for his view: In mid-March, Goldman Sachs forecast oil prices of $175 within two years while just yesterday (Tuesday), noted MSNMoneycentral columnist James Jubak predicted that oil would reach $180 a barrel in the next few years.

What’s "Fueling" the Oil Price Rocket?

Crude oil rose to a record $119.90 a barrel on the New York Mercantile Exchange yesterday, as the greenback dropped to an all-time low against the European euro. Crude oil is up 24% so far this year, and 88% from this time last year, Bloomberg News reported.
With this unrelenting march, it’s no wonder that industry observers continue to roll out ever-higher target prices for the "black gold."

If we’re only considering economic factors, the steep crude prices now being predicted would be unlikely to stick for any protracted period; there are huge new oil sources of oil that become economically profitable once oil rises above $100 per barrel. The Orinoco tar sands in Venezuela and the Athabasca tar sands in Canada - each of which contains larger oil reserves than the entire Middle East are viable even at $50 per barrel (Orinoco holds an estimated 1.8 trillion barrels and Athabasca 1.7 trillion barrels, versus a current Middle East estimate of 1.6 trillion barrels).

Then there’s Colorado oil shale - also containing at least 1.5 trillion barrels of reserves - that becomes economically viable at about $100.

The bottom line: If oil prices stayed at $180 to $200 per barrel for more than a year or two, huge new oil supplies would come on line, causing crude prices to plummet and tipping the market decisively back towards consumers. The environmental cost of getting really large quantities of oil out of Athabasca and Colorado would be immense, particularly if we attempted to supply the needs of the entire U.S. market from these sources, but at $180 per barrel, I’m confident that the economic necessity would probably trump the environmental problems.

As we said, however, these scenarios consider only economic factors. And as we’ll see, there are two additional factors that make this a much-less-straightforward analysis, meaning oil prices could linger at significantly higher prices for a much-longer period than economics alone would justify.

I’ve labeled these two "wild card" factors as "politics and a paradigm shift." Let’s look at each one.

First, political factors are increasingly restricting the areas that can be explored for oil. In fact, there are a number of places on earth where large reserves are known to exist, but political obstacles make it impossible to drill for—and remove—the crude.

So there it stays, heavily dampening an increase in production that would otherwise be taking place.

Second, world economic growth has been exceptionally rapid, and two huge population centers, India and China, have simultaneously been introduced to the joys of the automobile culture. And that’s created a major global paradigm shift that promises to shift the auto center of the world from Detroit to Shanghai, while simultaneously causing worldwide oil consumption to soar.

Now that we understand the demand side of the equation, let’s consider the outlook for supply.

Foreign Intervention

Countries that allow foreign oil-sector participation and avoid punitive taxation can reap two distinct benefits. First, production from existing fields is increased by greater efficiency. Second, modern exploration techniques are brought to bear, often resulting in new reserve finds in areas that have been closed to international exploration for decades.

For instance, it is especially noteworthy that Saudi production peaked in 2004, and that Saudi oil reserve figures are in doubt; indeed, most Saudi oil reserves derive from fields that were discovered in the 1970s, if not before.

To see how production may stagnate without the benefit of such outside participation, just take a look at Russia.

After 2000, Russia was the principal source of new oil outside the Middle East. Since 2003, however, the most efficient Russian oil company - Yukos NK OAO - has been dismembered, contracts with foreign oil companies such as Royal Dutch Shell PLC (RDS.A and RDS.B) and BP PLC (NYSE:BP) have been forcibly renegotiated, and Russia has imposed an 80% tax on oil revenue above $27 per barrel.

The result of these heavy-handed machinations has been pretty much what you’d expect: We recently learned that Russian oil production declined by 1% in the first quarter of 2008, following several years of rapid growth. An oil industry with capitalism, foreign partners and modern technology has given way to autarky and state control.

When it comes to foreign oil companies, other companies are adopting a game plan that’s very similar to that of Russia. Mexico bars foreign participation in oil exploration, and expropriates almost all the net revenue of its oil monopoly Petroleos Mexicanos, more commonly referred to as Pemex. Consequently, Mexican oil production is undergoing a steep decline: It is currently about 12% below its 2006 average, according to the International Energy Agency.

Mexican President Felipe Calderon is attempting to change that, by allowing Mexico to sign joint-venture agreements with foreign energy companies (the first such agreement under discussion is not with a hated "Yanqui," but is instead with Brazil’s Petroleo Brasilero SA (NYSE:PBR), usually referred to as Petrobras - itself a state-controlled enterprise, albeit one that’s much-more open to modern exploration techniques). However, even without proposing the politically impossible privatization of Pemex, Calderon’s attempted legislation is running into huge political opposition.

Other examples abound. Venezuela recently seized majority control of foreign owned oil concessions, so even with the world’s largest oil reserves in the Orinoco tar sands its production has declined by about 6% since 2006. Nigeria taxes foreign oil companies at 98%, so its production has declined 10% since 2006.

There are a few counterexamples. Where the oil industry is open, new reserves are found and production increases. Brazil’s Petrobras participates freely with foreign companies, and has discovered several large offshore fields recently. Iraq’s oilfields were opened to foreign participation after 2003, and Iraq’s estimated oil reserves have since doubled to 200 billion barrels, ranking it second behind only Saudi Arabia as having the largest crude-oil reserves in the entire Middle East.

Globally, oil production from existing fields has declined 7.7% annually since 2000, with British and Norwegian offshore fields showing a particularly sharp decline. That means that large new oil discoveries are required simply to keep pace with demand and to halt oil prices from spiraling up toward infinity. Allowing international participation in oil exploration and production is essential to this process, but the list of countries in which such participation is allowed has declined and appears to be diminishing further.

On the demand side, world oil demand grew by 1.1% in 2006 and 0.8% in 2007, even though the average oil price (as measured by the OPEC basket) rose from $50.64 in 2005 to $61.08 in 2006 (a 20% gain), and then jumped to $69.08 last year (for a 13% increase).

In 2008, world oil demand is expected to grow another 1.2%, even though the price has so far averaged $94.50 - a full 36% higher than in 2007. This suggests that demand is very price-inelastic in the short term, so that even a price rise towards $200 might dent it only modestly.

Since 2005, "easy-money" policies - global interest rates near zero, or even negative in real terms, after factoring inflation into the equation - has fueled a global growth boom that’s been unprecedented in its rapidity. Economic growth in China is still well above 10%, while that in India is running far above historical levels. Given those two countries’ huge populations, their tendency to control petrol prices and China’s massive switch from bicycles to automobiles, oil demand could well increase more rapidly than forecast. Since the Energy Information Administration predicts that demand will exceed supply again in 2008 - after doing so in 2007 - expect supplies to keep getting tighter.

This tightness is confirmed by the divergence in prices between West Texas and OPEC crudes. In a market where supplies were plentiful, any such difference would quickly disappear through arbitrage. In a tight market, supplies are constrained, so diverting cargoes to take advantage of arbitrage differentials may be impracticable. Currently, while OPEC crude sells for $109, West Texas crude is at $118, indicating an exceptionally tight supply situation.

Clearly, global oil prices are headed in only one direction - higher. And only a recession brought on by exorbitant energy prices or much higher interest rates is likely to cause a reversal.

Traditionally, if you wanted to invest in the world oil market, you bought shares in the world’s major oil companies, such as ExxonMobil (NYSE:XOM), Chevron Corp. (NYSE:CVX), Royal Dutch Shell or BP. That’s no longer a guarantee of success. The oil majors are the principal victims of the new trend of nationalism that’s sweeping the world oil market.

In country after country, their contracts are being renegotiated in a way that’s certain to crimp profits, or they are being pushed out altogether. Their oil reserves are declining; part of the return you get when you buy them is simply a return of capital as they slowly go out of business.

Crude Oil’s Three "Profit Pathways"

In today’s market, there are three possible approaches to buying oil stocks.

  • First, you can buy a company with a politically secure - albeit high-cost - oil source, such as the tar sands or oil shale. Of the pure tar-sands plays, the most attractive - with operations focused primarily on Canada’s Athabasca deposit - is Suncor Energy Inc. (NYSE:SU). On past earnings, the shares trade at a somewhat steep Price/Earnings ratio of 20, but that ratio drops to 11 when calculated on projected-future earnings since the higher oil prices for 2008 drop right through to Suncor’s bottom line.
  • Second, you can buy an oil company from a politically stable country that allows foreign participation in its projects, meaning the company is able to explore successfully using the latest technology. The best example here is the afore-mentioned Petrobras, which has recently made an oil discovery reputed to contain 33 billion barrels, by itself sufficient to vault Brazil well up the leader board of global oil exporters. Petrobras even qualifies as environmentally sound, if you care about that sort of thing; it is a major producer of ethanol from sugar cane, Brazil’s successful alternative fuel technology that is eight times as energy efficient as the United States’ hopeless ethanol boondoggle. Petrobras has had a hell of a run - with its shares having run up 138% during the past year - but the stock may well have further to go: It is trading at 22 times trailing earnings but only 18 times forecast earnings, and a continued success with its exploration efforts could push the shares up even higher.
  • Third, you can accept that many countries don’t like the United States - preferring, instead, to pursue inane socialist energy policies - and invest in a company that still offers them access to some modern technology when they do so. That company is Italy’s Eni SPA (NYSE:E), which has operations in Venezuela, Libya and Kazakhstan. Unlike the other two companies here, Eni is a bargain, trading at only 9 times trailing earnings and 8.5 times forecast earnings, and with a 5% dividend yield as an additional enticement.

Although these are three different approaches, they all have one objective: Take advantage of the continuing increase in oil prices. As Venezuela’s Chavez cheerfully gloats, we may still be a long way from the end of that trend.

Source: Three Ways to Profit From Oil's Record Highs