Rising Oil Prices Series: Part I

Posted by Patrick O'Connor on 6/4/08 1:53 pm

This post contains top-ten energy stock holdings from Navellier & Associates’ all-cap portfolios.

This article is the first installment of a six-part series about rising oil prices. In this column, we’ll explain why rising oil prices are of so much interest. In Part II, we’ll explain how the oil market works. In Parts III and IV, we’ll address the two main reasons for rising oil prices: increasing demand and limited supply. In Part V, we’ll delve into some peripheral issues: the weak U.S. dollar and the role of speculation. Finally, in Part VI, we’ll end with an outlook for the oil market.

Looking behind rising oil prices

Robust demand for oil has pushed prices from below $50 per barrel of crude at the start of 2007 to approximately $120 a barrel in 2008—above the inflation-adjusted $101.70 peak hit in April 1980, a year after the Iranian revolution.

To some, the price of oil comes as no surprise. In 2000, Sadad I. Al Husseini—head of exploration and production for Saudi Aramco, the Saudi Arabian state-owned oil company—tallied up some numbers he had been gathering since the mid-1990s and determined that oil output would level off around 2004, plateau for a maximum of 15 years, then begin a gradual but irreversible decline.

That’s hardly the kind of forecast we’ve been hearing from oil companies, especially Saudi Aramco, which sits atop some of the world’s largest proven oil reserves (including the Ghawar field), which altogether hold around 260 billion barrels of oil, around a fifth of the world’s known supply, according to National Geographic. And true to form, Saudi Aramco and Saudi Arabia’s oil minister downplayed the data.

Now, as in the past, when oil pessimists contended that a peak in oil supply was imminent, many naysayers, including oil companies, point out that much of the world’s conventional oil supplies are untapped; unconventional oil supplies, such as tar-sand pits, are yet to be fully explored; and constantly improving technologies are allowing us to dig deeper and extract more oil than we ever expected we could. These naysayers argue that today’s rising prices cannot be the result of dwindling supply, but instead are the result of sharply rising demand (especially from Asia). To illustrate their point, they recall past doomsayers who have predicted an oil shortage that never occurred.

While all of that may be true, today’s oil situation is a far cry from what we have seen in the past. Ordinarily, for example, higher prices encourage oil companies to produce more by investing in new technology and pursuing harder-to-reach deposits. This happened during the Iran-Iraq war in the 1980s, leading to a glut of oil. In the past few years, however, global output of conventional oil has hovered around 85 million barrels per day despite skyrocketing prices. Something is clearly different.

Some industry experts argue that oil companies are intentionally withholding supplies to keep prices artificially elevated. The Organization of Petroleum Exporting Countries (OPEC)—a group of 12 countries formed to maintain the price of oil at a level that is beneficial to its members—is the most widely cited culprit because it is often considered a cartel. Although OPEC’s ability to control the price of oil has diminished somewhat as oil reserves have been discovered in other countries, including Russia, OPEC nations still account for around two-thirds of the world’s oil reserves, and 35.6% of the world’s oil production as of March 2008. This undoubtedly gives the organization considerable control over the global oil market.

But other industry experts have suggested that there just isn’t enough oil, and in a few years, demand will outpace supply. Last fall, the International Energy Agency forecast that global demand would rise to 116 million barrels a day by 2030. But Cristophe de Margerie, head of French oil company Total, has said the world can produce at most 100 million barrels a day. And Royal Dutch Shell CEO Jeroen van der Veer has said demand will outpace supply as soon as 2015.

Asking how we got here results in a number of convoluted answers, perhaps none that are “right.” But, we know this: world demand is increasing as oil supplies dwindle - and why supplies are dwindling is an issue in and of itself.

Certainly, there are physical limitations: no one would argue that the world’s oil supply will last forever. Indeed, the volume of oil discovered has fallen each year since the 1960s despite technological advances such as seismic imaging that allows an oil company to see oil deep below the Earth’s surface.

But there are political issues as well. War-torn countries such as Iraq, for example, cannot access their full production potential due to security problems. Other countries, including Russia and Venezuela, cannot access their full potential because of restrictive laws prohibiting foreign involvement. Edward Morse, an oil expert who was formerly with the U.S. Department of State and now analyzes the industry for Lehman Brothers, says political obstacles may be larger than production issues. Many oil company CEOs, including van der Veer, have echoed that thought.

There is also the perhaps peripheral issue of speculation and the weak U.S. dollar. Earlier this year, Michael Masters, a portfolio manager for Masters Capital Management LLC, told a U.S. Senate committee on homeland security and governmental affairs that the real culprits behind rising oil prices are institutional investors such as hedge funds and sovereign wealth funds. The credit crunch has brought some markets, such as the U.S. asset-backed commercial paper market, to a virtual standstill. At the same time, the lowering of interest rates has created a supply of money for institutional investors. They, say Masters and others, are pouring billions of dollars into commodities such as precious metals and oil, which are a hedge against the declining U.S. dollar. The more the dollar slumps, the more attractive U.S. dollar-denominated oil is to foreign investors. This, in turn, is distorting markets and driving prices to unprecedented levels. Indeed, Masters says institutional investment in commodities indices has risen from $13 billion at the end of 2003 to $260 billion at the end of March 2008.

In this series, we’ll review these issues. But first, let’s take a look at the world oil market—how it has evolved and where it is today.  Go to Part II.

Navellier energy stocks that are top-10 holdings

Vantage Portfolio
Petroleo Brasileiro (PBR); 1-yr Chart; Profile
Sasol Ltd. (SSL); 1-yr Chart; Profile

Power Dividend Portfolio
Noble Energy Inc. (NBL); 1-yr Chart; Profile
Devon Energy Corp. (DVN); 1-yr Chart; Profile
XTO Energy Inc. (XTO); 1-yr Chart; Profile

All Cap Core Portfolio
Occidental Petroleum Corp. (OXY); 1-yr Chart; Profile

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Investment in equity strategies involves substantial risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any securities recommendations made by Navellier & Associates, Inc. in the future will be profitable or equal the performance of securities made in this report. For a list of recommendations made by Navellier & Associates, Inc., for the preceding twelve months, please contact Tim Hope at (775) 785-9416.

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