Rising Oil Prices Series: Part II

Posted by Patrick O'Connor on 6/4/08 1:39 pm

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

This article is the second installment (Read Part I) of a multi-part series about rising oil prices. In this column, we’ll review how the global oil market works—which is essential for understanding the economic analysis in the installments to follow.

A primer on the world oil market

In the mid-1980s, the price for a barrel of crude oil, adjusted for inflation to 2007 dollars, was under $25—and there it stayed until September 2003, when it began a gradual ascent that would take it to a peak of $135.09 in May 2008. That far exceeds the inflation-adjusted $101.70 peak oil hit in April 1980, a year after the Iranian revolution—so what gives? What’s driving up prices, and will they ever decline? We’ll get to that, but first, it’s important to understand the factors that influence the global oil market, including the role of the producers and refiners who impact not just oil prices, but the prices consumers pay for gasoline, heating fuel, and other oil-based products.

What is “oil”?

There are many varieties of oil, which is also known as crude oil or petroleum, but all are naturally occurring, flammable liquids found in the Earth’s rock formations. Because there are so many varieties, buyers and sellers refer to a limited number of “benchmark” oils. In North America, for example, the most widely used benchmark is West Texas Intermediate (WTI) oil, which is a light, low-sulphur crude. Varieties other than the benchmark are typically priced at a discount or premium to the benchmark, depending on how their quality compares to that of the benchmark.

Who produces oil?

A number of countries worldwide have crude oil deposits, and many are active producers. There is a great deal of concentration in the global oil industry; however, just 10 companies control 68 percent of the world’s proven crude oil reserves (and nine of these 10 companies are state-owned), according to Natural Resources Canada.

Since 1960, the global oil market has been significantly influenced by the Organization of the Petroleum Exporting Countries (OPEC), a consortium of 12 countries—Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela (plus Indonesia, which will quit after 2008)—formed to maintain the price of crude oil at a level that is beneficial to its members. Together, OPEC nations hold around two-thirds of the world’s crude oil reserves and produce 35.6% of the world’s supply as of March 2008, according to the Energy Information Administration (EIA), part of the U.S. Department of Energy.

TOP 10 OIL RESERVE HOLDERS
1. Saudi Arabia
2. Canada
3. Iran
4. Iraq
5. Kuwait
6. United Arab Emirates
7. Venezuela
8. Russia
9. Libya
10. Nigeria
Source: Oil and Gas Journal, 2006

TOP 10 OIL PRODUCERS
1. Russia
2. Saudi Arabia
3. United States
4. Iran
5. China
6. Mexico
7. Norway
8. Canada
9. United Arab Emirates
10. Nigeria
Source: Oil and Gas Journal, 2006

Who prices crude oil?

Traditionally, the law of supply and demand has determined the price of crude oil. When supply exceeds demand, producers try to sell excess inventory, and prices decrease. But when demand exceeds supply, consumers compete with each other for limited resources, bidding up the price.

Moreover, crude oil prices tend to be the same worldwide because the market is global. If there’s a shortage of crude oil in one part of the world, prices will rise in that market, attracting producers until supply and demand are in balance. Similarly, if there’s a surplus of crude oil in one part of the world, prices will fall in that market, attracting buyers who will bid up prices until they reach “equilibrium.” As a result, the only variation in world crude oil prices tends to reflect the cost of transportation.

That said, the crude oil market isn’t totally free because of the involvement of OPEC, which many people consider a cartel. To a great extent, OPEC sets the price of world crude oil, because when it wants to raise the price, it simply reduces production. How can this happen when many other countries also produce crude oil? - Because OPEC reportedly tracks the production of these nations and then adjusts its own production to maintain its desired price. (We say “reportedly” because OPEC has often denied this.)

Another factor influencing the price of crude oil is speculation. Crude oil is a commodity, and like other commodities, such as soybeans, it is widely traded by investors who see an opportunity to make money. These traders—called speculators because they’re not involved in the actual production or use of crude oil, but instead buy and sell paper contracts—can often influence market prices significantly. The two key markets where crude oil contracts are traded are the New York Mercantile Exchange (NYMEX) and the International Petroleum Exchange (IPE) in London. These are “futures” markets, meaning contracts are bought and sold based on expected market conditions in the coming months or even years. When the media quotes a price for crude oil, it typically quotes the futures market price in the most recent month.

Ultimately, crude oil ends up with refiners who convert it into gasoline and home heating oil, and marketers who sell it to consumers. Although refiners and marketers don’t directly influence the price of crude oil—except by demanding more or less of it based on consumer demand—they can influence the price of crude-based products. In March 2001, for example, the U.S. Federal Trade Commission (FTC) concluded that a spike in Midwestern gasoline prices was caused by one firm not selling its excess supply because doing so would have pushed down prices and thereby reduced the profitability of its existing sales.

Who uses crude oil?

According to the EIA, as of 2006 the United States used the most crude oil (20,687,000 barrels per day), followed by China, Japan, Russia, Germany, India, Canada, Brazil, South Korea, and Saudia Arabia.

As you may have noticed, many of these countries are developed. Indeed, the countries that make up the Organization for Economic Cooperation and Development (OECD)—a group of 30 countries that accept the principles of a representative democracy and free market economy—use the bulk of the world’s crude oil. Together, the United States, Europe, and Japan consume about half of the world’s annual oil output, according to Natural Resources Canada.

However, consumption in other countries, especially China, is expanding as these markets grow rapidly. According to the EIA, total energy demand in non-OECD countries is expected to increase by 95 percent from 2004 to 2030, while total energy demand in OECD is expected to increase by just 24 percent.

The transportation sector accounts for about two-thirds of the crude oil used in the world, and for about half of it used in the United States, according to Natural Resources Canada.

That’s important, because in our next installment, we’ll talk about demand—which many industry analysts say is the key factor in today’s skyrocketing oil prices.

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

We want to hear your thoughts!  Comment to this post by clicking the ‘comments’ link below.

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.

To receive email updates from Navellier All Cap Blog, click here.

• 
• Email
• Print
• Comments (2)

Posted by aWriter on 6/8/08 10:26 am

Thanks for the info on oil. I’ve read parts 1 & 2 so far. Interesting that I received in the mail an advertising piece from Byron King of Outstanding Investments newsletter entitled “The Great Oil Hoax.” It referred to the questionable nature of the oil-reserve numbers, esp. those from Saudi Arabia. King has some wild and wonderful investment suggestions such as liquified coal. Often, even usually, the excitement and concern seen now in the market seems overstated, even unwarranted, weeks, months and years later. Will that happen in this case?

Posted by Minnesota on 6/18/08 4:57 am

An adjunct to your Oil Blog II you may or may not know.

Over the last two weeks I taped, totally co-incidentally, four programs on CSPAN all relating to Oil prices.

The first was the G. Beck show when he had T. Boon Pickens on. When asked why Oil prices were so he high he simply stated, it is the law of supply and demand. He also mentioned some other number regarding US and world usage to support his claim.

About two days latter on Washington Journal Michael Greenberger was the quest. From 1997 - 1999 he was the Director of the Commodities Futures Trading Commission. He stated one of the reasons for high oil prices was the total absence of any Oversight control on oil Speculators.

He went on to say back in December of 2000 then senator Phil Graham introduced an amendment to a very large bill in the wee hours of the evening which REMOVED all Oversight from Mineral and Oil Speculators.  This went on to become known as the Graham / Enron amendment.

Greenberger also said he was appearing next week to testify before a senate hearing with G. Soros and others on oil prices.

The third program was the tail end of this hearing. During the hearing he restated what he had said on the Washington Journal program. Senator Dorgan of North Dakota, made the comment he would like to meet with him after the hearing.

The last program was just last week. It was on the senate floor where Senators were just giving promo speeches. The first happened to be Senator Dorgan. He was speaking about high oil prices, restated what Michael Greenberger had said about the Graham bill and went to say the Senate must do something to close this loophole.

After Senator Dorgan, Senator Bill Nelson of Florida spoke. He followed up on Dorgan remarks but added what I thought was confusing to Senator Dorgan’s statements. He said an amendment was already added to a bill the Senate had passed a few weeks ago, vetoed by the President but then passed again with a Senate Overriding vote.

The current caveat to this bill is, it needs to be re-written in one small area and again go through the passage, veto, overriding veto process. When this occurs the Graham / Enron loophole will be closed on Oil Speculators.

Please let me know of any corrections to the above.

Have a good week and keep up the good Blogs.

Post a Comment

You must register and log in in order to post comments.