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Crude Oil is Going to $500 a Barrel (Part 1)

Paul is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Now that’s a headline grabber!  Quantemonics Investing (QI) is projecting US$500 a barrel for crude oil in 8 years, basically compounding at the same rate as it has since 1999, between 2012 and 2020.  During 1999 the price for a barrel of oil was $10.  Today it goes for $110-$130.  Anybody predicting $100 a barrel for 2011 back in 1999 was considered a crackpot lunatic, and I am sure many reading this will say the same about such a ludicrous “prediction” of $500 in the not too distant future. 

I can remember telling people in 1999 that $10 a barrel petroleum and $0.75 a gallon gas were insanely cheap, especially when a gallon of water in a plastic bottle at the local grocery store was selling for over $1.00!  Imagine cheap oil, cheaper than tap water!  All the exploration and production expense, extensive refining and transportation cost, storage expense, marketing and retailing margins at the local gas station, and still it was cheaper than water!  Ah, the good old days of a God-given American right to low cost driving. 

In early 2012, it costs $1.00 to start your car, and at least $0.50 a mile to fully depreciate, maintain, fuel and insure most any automobile at $3.50 gas.  The average 10,000 mile a year driver is spending $5,000 annually to own and run a car.  The bad news is this critical cost of living and expense to run a business will continue to skyrocket during 2012-13 and beyond.  Interestingly, while mainstream prognosticators are confidently predicting oil will decline soon with today’s “Don’t Worry Be Happy” market sentiment backdrop, the truly contrarian stance may be to prepare for starkly higher oil and energy pricing.

Three undeniable variables are pushing oil prices higher and higher each year, and will not change much in the immediate future.  Record money printing by the U.S. Federal Reserve (FED) bank and central bankers across the globe, the Peak Oil supply phenomena (which basically explains why the world is running out of this important nonrenewable energy resource), and increasing levels of political chaos, revolution, civil disobedience and outright war between nations in the largest oil supply region of the Middle East are all pushing the envelope in supply/demand balance.  For most of 2011 and 2012, the world has been running a deficit in crude oil supply vs. demand of at least 500,000 barrels a day (U.S. Energy Dept. estimate), and this is before any increase in demand from economic growth or a supply shock from war with Iran.  Plus, the International Energy Agency is worried that necessary long-term investments in oil production and infrastructure are lagging mushrooming demand on the planet.

Record money printing from 2008-2012 in the world continues unabated, with the U.S. monetary base and M-1 money supply measures still rising at banana republic rates of +20% year over year in February 2012, three years AFTER the economic crisis bottom in the financial markets.  The root cause, foundation if you will, of the rise in oil (alongside other commodities) since 2009, is the truly insane and counterproductive base money creation and devaluation of the once almighty U.S. Dollar by the Federal Reserve.  If you want lower oil and gas prices, you need normal levels of money printing and “real” interest rates HIGHER than the honest consumer inflation rate of +5% annually in early 2012.  (I could stop here, because a normal level of money printing the last three years would have likely kept oil near the early 2009 number of $45 a barrel.)

Then you have the Peak Oil problem.  Once we pump oil reserves out of the ground and burn them to produce energy, they don’t come back!   Oil resources are extremely limited and becoming more so as the emerging economies like China and India continue to grow strongly.  Mathematically the supply of oil is not keeping pace with steady increases in demand, and the cost to find and pump new oil reserves is skyrocketing from its scarcity.  Today we have to crush rocks and squeeze sand and drill 4 miles under sea level to find significant reserves.  Then what will we do when these run dry?  Just last week ExxonMobil (NYSE: XOM) announced they will produce less oil in 2012 than 2011, and they employ a growth oriented business model!  Even with high oil prices as incentive, it is getting harder and harder to find new oil reserves that can be exploited for profit, since the cheap oil on the planet is now GONE.  If you are an optimist on economic growth in the world, you will have to deal with the devil of skyrocketing oil and gas prices, pure and simple.  That’s the math - I cannot change the facts.  Going forward, rising demand and stagnant supplies will force prices higher, basic economics at play, if you want new reserves to be found and pulled up from the deep.

Now let’s turn our attention to the volatile Middle East situation of 2011-12, and the high likelihood of trouble with Iran soon.  As oil prices have exploded, so have fights over the ownership and return of profits to the people of the Middle East region.  Largely run by an elite, royal, or dictatorship hierarchy, the Middle East nations accounting for 30% of global oil production have been descending into chaos and war since the Arab Spring of 2011.  Tunisia, Morocco, Libya, Egypt, Syria, Iraq, Bahrain, Jordan, Kuwait, Yemen and others are witnessing chaotic changes in leadership and direction, as the lower class majorities have been left the scraps of oil riches for decades.  On top of this violent turbulence, huge oil discoveries in the Mediterranean Sea in 2010-11 are causing new friction between Israel, Syria and Turkey.

Of course, front and center for the world is Iran’s nuclear weapons push.  While Iran has done a decent job of deflecting attention and pretending they are not up to anything of concern for a good decade, it is undeniable in early 2012 they are close to having enough enriched uranium to make a bomb or two and are working hard on delivery systems to threaten their neighbors after several ballistic missile test fires in 2011.  Conservative United Nations estimates place Iran with a crude nuclear bomb by the end of 2012, and potentially one on a rocket by mid-2013.  Iran is making overt threats to not only attack Israel, but also Arab neighbors like Saudi Arabia and Bahrain that house thousands of U.S. troops, plus close down the Strait of Hormuz in the Persian Gulf.  Such a closure of this important transportation passageway for oil could roil the supply flow to the rest of the world, even if it lasts just a couple of weeks, with supplies already declining to hazardously low levels globally.

One fallacy floating around Wall Street currently is the price of oil “cannot” rise further because it would slow demand dramatically.  History says otherwise.  Several Middle East wars and crisis supply shocks made for political reasons against western economies caused the price of crude oil to climb from $3 a barrel to $40 between 1973-81.  During this span there were two rapid spikes in price of better than 200% over less than a year.  The 1990 Iraqi invasion of Kuwait and U.S. response to repel Iraq, forced a rise in global oil prices of nearly 200% in four months!  Truly inelastic demand for oil and energy is the reason.  The economy will slow down from related dislocations to disposable income and a rise in inflation.  Yes, it will even slip into recession.  However, I have confidence the Federal Reserve will swoop down and double or triple the banana republic rate of money printing to ease the pain of our $200 a barrel target price for 2012-13 (triple the $75 low in October 2011), and allow the overall CPI inflation rate to skyrocket past 10% later in 2012-13.  FED Chairman Ben Bernanke loves to print money, like it grows on trees, and he cannot wait for another crisis to save U.S. all.  (Nevermind the coming spike in interest and inflation rates from oil’s climb will make Uncle Sam’s $18 TRILLION in debt rollovers impossible to refinance.  I will leave the Treasury’s out-of-control structural deficit financing problem for future blogs.  I wrote a little article on Motley Fool in December 2009 on How to Fix America - nobody listened.)

So which oil stocks do we own in the Quantemonics Relative Value portfolio on Covestor.com?  Basically we have focused on U.S., Canadian and European North Sea assets, far from the Middle East turmoil.  The best “margin of safety” strategy is to own oil and gas producing assets and reserves in the politically safer and stable areas of the world.  The vast majority of international oil conglomerates from Exxon to British Petroleum (NYSE: BP) to Shell (NYSE: RDS-A) and Chevron (NYSE: CVX) hold significant assets in the Middle East.  Given many potential scenarios like the destruction of oil facilities in a war or large terrorist attack, the nationalization of properties after a military coup or revolution by the people, or the shutdown of transportation pipelines and shipping routes, getting product to market when prices are even higher in the future is a risky proposition for Middle East assets.

Our biggest single company holding in Relative Value is ConocoPhillips (NYSE: COP).  Of the large integrated conglomerates, COP has the best concentration of assets in the U.S. and other politically safe nations.  The company is splitting in two in 2012, which should serve as a second strong catalyst for investors, after the spike in oil.  They are spinning off the exploration and production assets (upstream) from the refining and marketing assets (downstream).  Management believes the company is undervalued by Wall Street, and a separation of units will help them to focus on even greater profitability.  Warren Buffett’s Berkshire Hathaway owns COP as its largest oil and gas holding, and is surely on board with the expected positive wealth effect for stakeholders coming after the spin-off.  You can review the latest COP 10-K filing with the SEC here for more research.

A major reason gasoline prices are projected to rise into the US$4-$5 a gallon range during mid-2012 by most economists revolves around the changing refinery line-up in the U.S., with five closing down for good from age and high cost.  Changing EPA rules, old age, and the types of crude oil refined have made many East Coast refineries big money losers for oil company owners.  You cannot blame them for shutting down money losing operations.  The net effect will be much lower supplies of gasoline than last year, and we could even see shortages of refined product by the summer driving season in some areas of the nation.  Considering how difficult it is to get regulatory approval to build a new refinery, and the number of years it takes to construct one, consumers may have to deal with extremely high gasoline prices, no matter what happens with the supply of Middle East oil!

After the ConocoPhillips downstream spin-off, the separated unit will be the largest publicly owned, independent refinery business in America with 12 plants in the U.S. and four in other nations.  The marketing, transportation, storage and refinery business will likely be quite profitable and grow more so into 2013, as the supply/demand balance shifts heavily in favor of refinery business owners.

Quantemonics plans to hold both ConocoPhillips business units after separation.  Not only will the refinery unit witness strong demand from investors, but the diversity of COP’s oil production reserves across the planet, with a low weighting in the Middle East, is an attraction proposition for safety minded investors.  More than half of its total oil and gas production came from U.S. assets, and 75% of total sales were made in America during 2011.

High levels of profit margin and free cash flow, a high dividend yield, a decent balance sheet and other data points give ConocoPhillips shareholders a great financial foundation moving into a strong rise in oil pricing.  We expect the split units to remain conservative capital allocators, and their existing asset bases should be enough to translate into terrific stock market gains when energy prices do spike.

(Part 2 will discuss our other Oil and Gas holdings.)

<img src="/media/images/user_2224/cop_large.png" />

Chart courtesy of StockCharts.com

FULL DISCLOSURE: We hold ConocoPhillips (COP) shares long in our mirror portfolios on Covestor http://covestor.com/quantemonics-investing/relative-value and unrelated personal accounts. We do not currently hold positions in any other stock mentioned in this article. Quantemonics Investing, LLC is paid as a general publication information and data provider. All contents of the Quantemonics Investing service and blogs on the Motley Fool website are provided for information and education purposes only. You agree that the service is not to be interpreted as investment advice, as an endorsement of any security or investment, or as an offer or solicitation to buy or sell any security. Quantemonics, www.quantemonicsinvesting.com and the owners and officers of Quantemonics Investing, LLC do not provide specific and personalized investment advice, and are not registered as investment advisors or a broker/dealer. The trading of securities or investments may not be suitable for all users of the service. It should not be assumed that future results will be profitable or will equal past performance, and all readers should understand each security investment involves a degree of risk. Investors should not assume that profits or gains will be realized by any security or investment mentioned by the service or related blogs. Readers accept any and all potential liability, loss, expense and cost when making trades or investments in their own account. We recommend readers consult with a registered financial adviser before making any investment decision. Investors should not hold more than 5% of their portfolio capital in any single equity position, as a general rule of diversification. No compensation of any kind has been paid to Quantemonics Investing, LLC or related parties for company participation in our data service. The facts and information presented have been obtained from original or recognized statistical sources believed to be reliable, but their accuracy and completeness cannot be guaranteed. All opinions expressed on the service are subject to change without notice.

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