Big Oil Pricing in $100 Barrels: Any Upside?

Includes: BP, CVX, OIL, XOM
by: Joseph E. Meyer

A number of variables have helped push big oil stock prices higher this month, not the least being expectations of higher oil prices in early 2011. Brent crude oil prices have already broken $90 a barrel in the futures market, while NYMEX sweet and light crude is hitting $90 on Monday and pushing higher on Tuesday as the market cheers tax cut extensions for the wealthy.

The market is considering higher oil prices regardless of tax cuts and I think that's one of the key variables at play to the recent rise in Exxon-Mobil (NYSE:XOM), Chevron (NYSE:CVX) and even BP PLc (NYSE:BP). We rose to fresh two year highs for oil futures on Monday and Tuesday, and that has helped some big oil stocks.

Although big oil stocks do not necessarily follow oil prices, equity of oil companies has mainly outperformed one of the bigger oil futures exchange traded notes, the iPath S&P GSCI Oil futures index (NYSEARCA:OIL).

I wouldn't be willing to bet that oil companies continue with this kind of killer upside over oil futures, but I do believe oil as a commodity will rise even as the U.S. and European economies hobble along on one leg.

Upside for oil?

There is. But wait for a pullback in the futures market to support levels of around $78 a barrel for West Texas crude. The current 200 day moving average for West Texas Intermediate crude (WTI) was $79.43 as of Monday's close. A healthy correction is likely if OPEC -- meeting next weekend in Ecuador -- opts to increase production or its production quota. All corrections in price should be contained at the 200-day moving average, marking a great entry into oil. JP Morgan's recent oil forecast is that OPEC will not increase production unless we hit $100 a barrel.

Consider these bullish oil factors:

1. International Energy Agency ups 2011 demand forecast.

The crude oil market has been very strong since September, having been locked in a trading range and underperforming all core commodities. Since January the trading range has been confined between $69.50 per barrel on the downside, and $88.50 on the upside. Resistance has been broken and we will see a breakout to much higher prices in 2011. One of the fundamentals leading to breakout forecast are the latest figures from the International Energy Agency (IEA), which state that global oil demand will reach 88.2 million barrels a day by 2011, led by China. This will be an increase from 86.9 million barrels a day currently.

These numbers go up and down every month so should not be taken as gospel. But they do lend credence to recent calls of $100+ oil prices next year.

2. Winter's impact.

The entire energy sector continues to show strength. The fact that natural gas has successfully tested the low at the $3.00 level twice indicates to me that technically, we are now poised for higher crude oil and natural gas prices in 2011. The severity of the winter season is already being felt in many parts of the country. That means oil will experience its seasonal increase in demand. In fact, the U.S. Energy Information Agency expects the price of WTI crude oil to average about $83 per barrel this winter (October 1 to March 31), a $5.50 per-barrel increase over last winter and $3 per barrel more than last month.

Also according to EIA projections, WTI price averages should rise gradually to $87 per barrel by the fourth quarter of 2011. We've beat that already in the spot market. I would expect a healthy pullback if you're already investing in an oil play. If not, when the pullback does come, get in on the leadership names in the sector and hold them for a couple of years.

3. Gold-to-oil ratio.

In 1980 it took 34 barrels of oil to equal one ounce of gold. Currently the ratio is about 16 barrels of oil to equal one ounce of gold. The point I am making is that the number of barrels of oil needed to equal one ounce of gold at current prices has been cut by 50 percent. I believe before the commodity bull market is complete we will see at a minimum the number of barrels of oil needed to buy an ounce of gold cut in half again. The data is clear; we are on the threshold of a decent increase in energy prices. It would not be unreasonable to see the acceleration in energy demand, at some point coupled with shortages to occur globally during an economic recovery. I see oil approaching $200.00 in 2012 and $300.00 per barrel in 2013 if new supplies are not made available and if the U.S. and European economies are steadily growing over 3.5% in full recovery mode.

There are entry risks right now, though. Oil stocks have had a nice run recently and will be ripe for a decent correction when the overall stock market corrects its recent advance. Whenever the equity market finally undergoes a correction it will initially take everything down with it. The other risk to energy is slower than expected growth in emerging market leaders like China and India, and U.S. unemployment pushing over 10%.

As a caveat, we are past peak oil production and the large energy fields are well past production peak levels. Deep water oil discoveries like those found in Brazil are extremely expensive and not enough for an oil hungry world. I always like to keep things simple and recommend buying the quality companies with strong dividends that allow investors to approach the sector of the market on a total return basis. Look at buying the leadership in the oil sector and add to them on any significant weakness in prices. I like a one-third commitment to the oil service sector, a one-third allocation to the international oil companies and a one third commitment to the high quality natural gas leadership stocks as a buy and hold with buys on the dips for the next two to three years.

Disclosure: No positions