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Jim Kingsdale wrote an article on Seeking Alpha yesterday entitled "A Case For Retreating From Oil Investments." I wrote the following piece in the Comments section, but have decided to submit it as a complete article as well. I have been bullish on oil and gas for more than a year, beginning well before oil crossed $100, and I remain so today. Although I have been bullish on oil, I never called for oil to hit $150 this year, or, perish the thought, $200.

In an article I published here in early 2008, I said I expected oil to cross $100, cross $110 and test $120, but then spend most of this year between $100 and $120. That remains my prediction. In my predictions, I did miss the irrational rise to almost $150, and perhaps I will be wrong again and oil will go below $100 and stay there for a while.

But I doubt it.

As Mr. Kingsdale has correctly stated, all the bearish factors he discussed in his article could have been perceived 45 days ago. Indeed, they could have been perceived 145 days ago. So that is not the reason for Mr. Kingsdale's change of heart about the suitability of oil as an investment. Instead, his change of heart is due to his "listening to the market."

But, at most, the market today is telling us that oil was overpriced at $147. It is not telling us that oil is overpriced at $115. Yes, I know that some of the technicians in the crowd believe that oil's recent swoon indicates it's going to $60. But those technicians didn't tell us it was going to go to $147 less than two months ago, so we can all admit that technical analysis of where oil is going to be next week or next month is almost useless.

What does help is a supply-demand analysis, which the author has done, but I think he has missed some very key factors, which I discuss below. First, and perhaps of greatest importance, Mr. Kingsdale dismisses the thought that Saudi Arabia [SA] will reduce oil production because it is "committed" to producing more. I'm not sure what "committed" means, but I know that one phone call from the King could reduce Saudi oil production by 1 million barrels per day [mpd]. I wouldn't be surprised to learn at some future time that some of the 500,000 bpd in increased production that SA ramped up in May and July of this year has already been reversed, and if oil breaches $100 (which it might well do in the next month or two), expect OPEC (not just SA) to announce a reduction of up to 1 mbd at their next meeting.

The King and the Saudi oil minister have said on several occasions that Saudi oil should be saved for future generations. $80 oil would provide a powerful incentive to do exactly that--especially since SA knows that if they wait just 2-3 years, the world oil situation will be much tighter and they will be able to get much more for their oil.

The other factor not taken into account by the author is that a significant portion of marginal oil production today is simply not economical at $70 to $80. Will the Brazilian Tupi and Carioca fields be produced if PBR believes all it can get for that oil is $80? I highly doubt it.

Will the Arctic be drilled (assuming it's allowed) for $80 oil? Again, I doubt it. I realize these are longer-term projects that won't produce in the next 2-3 years, but even today, there are a lot of marginal fields being pumped for $120 oil that will be shut down if only $80 can be gotten for that oil. Many enhanced oil recovery and tertiary techniques, and even oil sands production, are not very profitable at an $80 price point.

Finally, it has often been said that "the cure for high prices is high prices," but the same works in reverse--"the cure for low prices is low prices." If oil goes back to $80, and gas back to $2.50, demand reduction will be muted, if not entirely reversed. This, combined with lower production, will act as a self-correction mechanism to low oil prices.

In summary, I believe that oil will continue to trade between $100 and $120 this year, and that certain oil-related investments are worth holding. Of course, if Israel attacks Iran or the Middle East destabilizes in some other way, oil could well test $150 this year.

In the past year, I have played oil very simply--by buying and holding shares of three Canadian royalty trusts--HTE last year, and PWE and PVX this year. Despite the gyrations in the oil market--and even in the value of these stocks, I am about at break-even with them. But in the past year--which has not been kind to the markets--I have collected about 15% in dividends. Thus, my total return of 15% is not bad given what has happened in the markets in the last 12 months.

And these generous dividends will continue to be paid unless oil goes under $80 and gas under about $7.50, the likelihood of which I believe is very low (well under 10%). Of course, if these stocks drop another 10% (which they might if oil goes to $100), I will buy additional shares which will then yield nearly 17%.

To me, these stocks offer a wonderful dividend, which also protects against any major drops in the stock price, while offering substantial upside over the next few years.

Disclosure: I hold a large long position in both PVX and PWE.

Source: CANROYs Remain Attractive as Oil-Related Investments