Rising Oil Prices Series: Part VI

Posted by Patrick O'Connor on 6/19/08 1:51 pm

This post contains Navellier top-ten energy stock holdings.

This article is the sixth and final installment of a multi-part series about rising oil prices. In this column, we’ll review the issue and discuss the outlook for oil prices. Read parts I, II, III, IV, and V.

Oil, oil, toil and trouble

When oil prices skyrocket as they have—from $60 a barrel in 2007 to more than $130 a barrel today, recording highs on nine of the 22 trading days in May 2008—it’s natural to assume that something or someone must have caused it, and to look for a culprit.

As a result, consumers and industry watchdogs have started taking names. Some say the world is simply running out of crude oil. Some blame developing countries such as China for increasing demand. Others say the big oil companies are taking advantage of high demand to manipulate prices. For a while, the weak U.S. dollar was targeted. Most recently, speculators have been on the hot seat.

All of these factors are likely playing a part in rising oil prices. Demand is clearly growing. It’s no surprise that oil companies want to increase their profits; they are, after all, in the business of making money. And, as the value of the dollar has fallen and inflation has risen, speculators have certainly flooded the market with buy and sell orders.

We may not know exactly why oil prices are rising, but we know they are, and they will probably continue to do so. You’d think that for $130 a barrel, oil companies would want to explore and produce more, but their caution is understandable. Oil prices can swing wildly—just a decade ago they were less than $10 a barrel—and no one wants to make an investment that won’t pay off. After all, the capital costs of getting oil out of the ground have increased drastically in recent years, partly because of rising steel prices. In February 2007, ExxonMobil and Qatar Petroleum cancelled plans for a $7 billion plant that would convert methane into synthetic diesel in Qatar—in part because of rising steel and aggregate rock prices and cement shortages.

So, what will happen to the stock market if oil prices continue to rise? Oil prices have increased more than 450% in the past five years, rising from around $25 a barrel in 2003 to a high of $139.89 recently. If they increase by the same amount in the next five years, they’d exceed $700 a barrel in 2013. That would make oil unavailable to much of the world, and as a result, significantly decrease economic activity. And that would almost certainly lead to extreme stagflation—an inflationary period accompanied by rising unemployment and lack of growth in consumer demand and business activity. Almost certainly, the markets would not perform well at such a time.

But much could happen to change things. Higher crude oil prices could dampen demand or drive increased supply, which could stabilize or reduce the price of oil. For example, the profligate use of oil in the U.S. automobile sector could be reduced by the production and use of more energy-efficient cars. But many industry experts consider this unlikely, at least on the demand side. The benefits of converting to energy-efficient cars may be overstated: while some hybrid cars reportedly get up to 50 miles per gallon, others get as low as 20. And even if hybrid cars could change the world’s dependence on oil, it would take 17 years to completely refresh the U.S. automotive fleet, according to the Hirsch Report.

Additionally, we have to consider the possibility that oil prices just aren’t affecting the global economy the way we’d expect them to. An old rule of thumb says that every 10 percent rise in crude oil prices will lead to a 1 percent drop in global growth—but that’s not happening today. The National Institute of Economic and Social Research—an independent economic research organization in the United Kingdom—says U.S. economic growth is only 0.7 percent less than it would have been without the past year’s rise in oil prices. Growth in Europe and Japan is only 0.5 percent less, and growth in the United Kingdom is only 0.25 percent less. Why? Because economies are less sensitive to oil prices than they used to be, according to the Institute. The amount of oil, coal, and gas needed to produce an increase in gross domestic product has halved since the 1970s, thanks to greater energy efficiency and the shift away from heavy manufacturing. Plus, labor markets have become more flexible, with workers accepting temporary reductions in real wages when energy prices rise instead of demanding increased compensation.

So, how high will crude oil prices go? No one knows for sure, but in a February 2008 report, Deutsche Bank predicted that they may peak at around $150 a barrel. Daniel Yergin, president of Cambridge Energy Research Associates, also thinks $150 is likely. That, suggested Deutsche Bank, may be the “magic” price that destroys demand to the point that we could live with a world supply of 100 million barrels per day, which, as noted earlier in this series, is what many industry executives view as the maximum supply available.

In any case, we’re bullish on oil stocks in the near-to-medium term. We don’t think the oil bubble will burst until there’s more evidence that both demand and supply are responding to higher prices. That becomes more likely as prices rise, but it will almost certainly take time, partly because much of the world’s oil is purchased on long-term contracts, and thus does not reflect current market prices.

Moreover, there are a number of other industries that could be positively impacted by today’s rising oil prices as well. For example, new models of hybrid cars use lithium-ion batteries that are lighter and more powerful than the old batteries. We read one estimate that a Toyota Prius with a lithium-ion battery can get 80 miles per gallon of gasoline. So, one might consider investing in companies that make lithium or lithium-ion batteries.

Navellier Top-Ten Energy Stock Holdings

Vantage Portfolio
Petroleo Brasileiro (PBR); 1-yr Chart; Profile
Sasol Ltd. (SSL); 1-yr Chart; Profile
Encana Corp. (ECA); 1-yr Chart; Profile
Cameron Intl (CAM); 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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