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By Robert Rapier on May 22, 2009 with no responses

With Oil Prices Poised to Jump as Much as 70%, Every Investor Needs an Energy Strategy

[RR note: This blog occasionally posts guest posts, and energy investing is a topic that is visited on a fairly regular basis. The website Money Morning recently noticed that I had linked to one of their articles, and asked if I would be interested in publishing some of their original energy-related content. Because their energy posts are generally consistent with the theme of this blog - and because I often find myself with little time to post - I will be posting some of their original content here. This doesn't imply that I endorse everything in the story, but then again that was never the case previously with guest posts. These posts are designed to educate and promote discussion, and I will participate in the comments following these posts.]

With Oil Prices Poised to Jump as Much as 70%, Every Investor Needs an Energy Strategy

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

The U.S. news media has convinced many investors that oil consumption is falling because of the global recession. While that may be true, it’s a disservice to millions of investors because production is declining at a pace that’s actually three times faster.

And that suggests higher oil and gasoline prices in coming months – perhaps as much as 50% – 70% higher, or more – particularly if a U.S. economic recovery is truly in the offing.

To really see what I’m talking about, let’s start with a close look at consumption. I’m asked about this frequently in my global wanderings, most recently at the Las Vegas Money Show last week.

For months we’ve been hearing about a drop in global demand. It’s a popular story and one that sounds credible: After all, it seems logical to assume that during economic chaos, consumers and businesses alike will rethink their budgets and ratchet back their spending.

For consumers, the continued economic malaise will mean fewer trips to the store, less-ambitious vacations, and car-pooling to school or work . For businesses, the cutbacks by consumers will clearly translate into canceling trips where conference calls will suffice and using lower-cost shipping alternatives for the decreased sales volumes most U.S. companies will experience.

According to the U.S. Energy Information Administration, oil consumption fell by nearly 50,000 barrels a day throughout 2008. According to the latest figures, the EIA suggests that global oil demand may slump to 83.4 million barrels a day in 2009 – nearly 2.4 million barrels below 2008 consumption levels. On a percentage basis, that’s almost a 3% drop. I have my doubts that we’ll actually see a decline of this magnitude, but if it does occur, it will be the first time ever that consumption has declined for two straight years. That alone is pretty noteworthy in this era of cohesive and powerful global growth.

The reason I have my doubts about such a steep decline in demand is this: While overall consumption is dropping in such developed economies as the United States, Europe and Australia, it’s being at least partially offset by continued growth in China, the Middle East and Latin America. Because the data produced there is less than transparent, I can’t help but think that analysts are underestimating the growth we’ll be seeing in those markets, where consumption is accelerating strongly. And it’s entirely possible that growth in those markets will outstrip any fall here in the developed world.

Even if the growth in the emerging markets doesn’t quite offset the decline in their developed brethren, analysts seem to be forgetting that oil prices are a function of two variables – consumption and production. And it’s the change in production that’s going to catch a lot of people by surprise.

After a run of record high oil prices punctuated by frantic resources development, we’re now seeing the opposite scenario. The long period of lower than anticipated oil prices following oil’s meteoric rise last year means that the entire industry is no longer making the investments needed to sustain production capacity or actual production.

And not many folks recognize this fact.

For instance, direct project investment in drilling may be down as much as 20%, while the number of drill rigs in operation in America alone has dropped by more than 40%. Various estimates from the EIA and private sources suggest that actual U.S. production may fall by as much as 320,000 barrels a day. While the amount is a matter of debate, the fact that production is declining is not.

More than 20% of total U.S. oil production comes from tiny wells located in remote areas that were marginally profitable producers when crude oil was trading at $100 a barrel. With oil currently at about $61 a barrel, those producers are practically worthless now. So the “mom-and-pop” shops that own them are actually abandoning entire fields and equipment without a moment’s thought.

To be fair, at least part of the drop in demand can be attributed to increased reliance on methanol, ethanol and other types of biofuel, but that’s hard to quantify at the moment because the long period of low oil prices has eroded the economic viability of alternative fuels – at least for now.

The story is much the same with new exploration projects being cancelled left, right and center. The trend is particularly apparent in the Canadian oil sands that were everybody’s fancy only 24 months ago. Now we’re seeing Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B), StatoilHydro ASA (NYSE ADR: STO) and Petro-Canada USA (NYSE: PCZ) each backing away from multi-million dollar investments that were to bring online an estimated 500,000 barrels a day.

Russian, Saudi and Mexican producers are reporting the biggest production drops seen in 50 years. Even Venezuelan leader President Hugo Chavez – the perennial motor mouth and longtime U.S. critic – is eating crow. He’s begrudgingly invited (read that to mean “is begging”) the oil companies whose assets he nationalized only a year ago to “come back” into the market.

He has no choice. Venezuela’s oil production is already below its 1997 levels, and many analysts say that output could fall even more since Chavez has done such a thorough job of alienating the big foreign oil companies that actually possess the technology needed to extract crude oil from that country’s hard-to-reach reserves.

Chavez’s Chavez’s government seized the assets of 60 foreign and domestic oil service companies after conflict erupted over nearly $14 billion in debt owed by the country’s state-owned energy company, Petroleos de Venezuela (PDVSA). PDVSA accumulated the debt as oil prices took a dramatic slide from over $147 a barrel last July to less than $35 a barrel in February.

Then there’s simple shrinkage. This is an oil industry term for declining output. The EIA recently released data suggesting that production at more than 800 oil fields around the world is going to decline by about 9.1%. It doesn’t matter whether the decline is prompted by depletion, war, or simple neglect. The fact is that this shrinkage will take an estimated 7.6 million barrels per day out of the system.

I could go on but I think you get the picture.

Now imagine what could happen to oil-and-gasoline prices when normalized demand resumes. Not only will there be less oil in storage, but virtually the entire industry – exploration, production, refining and sales – is going to be caught sitting on its heels when the world needs it to be zooming along in high gear. And that means the companies that make up this industry will have to ramp up again to meet the newly increased consumption demands.

This whole process could take two years – or even longer – to play out.

As for prices, history is replete with examples of what happens when there are major shortages of key commodities.

In the Energy Crisis of 1973-74, for example, I can still remember the numbingly long gas lines and waiting in the car for hours to get a fill-up. My father and grandfather vividly remember that prices quadrupled in a matter of months. I’m sure you do, too.

Only a few years later, in 1979, we got another oil shock when prices quadrupled again. Because it was coupled with stagnant economic growth and virulent inflation (stagflation), this period was an economic disaster for the United States.

For those who had learned from the earlier crisis, however, it was a mondo- profit opportunity.

The same can be said for 2007-2008, when the huge spike in oil prices that I predicted contributed to the bear market in stocks, tight credit and recessionary conditions that led to the current malaise that continues to grip the U.S. economy. As much as anything else, high oil prices contributed to the carnage we’ve seen in the auto-making and airline industries, and to the financial crisis that started here before spanning the globe.
Which brings us full circle.

Many investors will refuse to believe we’ve arrived at this new energy nexus, especially given all the hype we’ve seen surrounding alternative fuels, hybrid vehicles and the new “green” mentality that’s taken hold here in this country. If you listen to some of the real believers, they’ll tell you that we could be living in a petroleum-free Nirvana – as early as tomorrow.

While I personally would like that, too, it’s a misleading argument if for no other reason than there are millions of consumer items we use – from plastic bags to makeup – still created using petroleum. And there are still more than 60,000 manufacturing processes that depend on petroleum, and even the most aggressive estimates suggest that it will take the world decades to shift away from them.

We’re in much the same situation when it comes to hybrid vehicles. There isn’t a mass-produced electric vehicle available today that could offset the coming rise in recovery-driven demand for oil and gasoline. There’s a strong effort underway, but I’m not aware of a single company ready to field the solution in cost-affordable quantities by 2010 – which is when most analysts say a recovering economy will stoke demand for oil.

Of course, U.S. President Barack Obama’s much-lauded efficiency and greenhouse-gas-standards mandate will help significantly, but that’s like bolting the barn door after the horses have run for the fields. The irony of watching auto executives “applaud” his press conference was almost too much to watch with a straight face. But that’s a story for another time.

The bottom line is this: Our society will be highly dependent on oil for many years to come and investors should plan accordingly.

If governments around the world really want to get serious, they could collectively work to eliminate the fuel subsidies that are part of the price paid for gasoline in Asia or sugarcane ethanol in Brazil. We could also stop our own energy pork barreling. But given the complete lack of transparency that surrounds this issue – not to mention the influence wielded by vested industry interests, and the scores of well-paid lobbyists that patrol the halls of power in our nation’s capital – I don’t think we’ll see any big changes anytime soon.

So I’m left with one inescapable conclusion, at least in the intermediate term. Every investor needs to have at least some sort of energy strategy – preferably one that includes a range of drillers, producers and suppliers to cover the spectrum from wellhead to consumer.

That way, we can profit from an increase in energy prices that we can only hope rise fast enough to jump-start the oil industry’s production arm but not so fast that it snuffs out the badly needed economic recovery.

[Editor's Note: Money Morning Investment Director Keith Fitz-Gerald is the editor of the new Geiger Index trading service. As the whipsaw trading patterns investors have endured this year have shown, the ongoing global financial crisis has changed the investment game forever. Uncertainty is now the norm and that new reality alone has created a whole set of new rules that will help determine who profits and who loses. Investors who ignore this "New Reality" will struggle, and will find their financial forays to be frustrating and unrewarding. But investors who embrace this change will not only survive - they will thrive. With the Geiger Index, Fitz-Gerald has already isolated these new rules and has unlocked the key to what he refers to as "Golden Age of Wealth Creation" The Geiger Index system allows Fitz-Gerald to predict the price movements of broad indexes, or of individual stocks, with a high degree of certainty. And it's particularly well suited to the kind of market we're all facing right now. Check out our latest report on these new rules, and on this new market environment.]