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Economics: Are you Ready for $100 Oil?
New York: April 04, 2005
By John R. Stephenson

"We believe oil markets may have entered the early stages of a "super spike" period, which we now think can drive oil prices toward $105/bbl."

--Goldman Sachs analyst Arjun N. Murti in his March 30, 2005 research report.

Can you imagine paying $4 per gallon at the pump? According to Goldman Sachs, that's exactly how much you might need to shell out to keep your car on the road in the years to come. Not only is Goldman Sachs sounding the alarm but Adnan Shihab-Eldin, the acting Secretary-General of OPEC,recently voiced the opinion that there is a reasonable probability of oil spiking to $80 per barrel if a major supply disruption were to occur. Why all the concern over oil prices? Because supplies are tight and demand is increasing faster than anyone previously envisioned.

Oil production has been in decline for many years while, at the same time, the economies of Asia and the U.S. have been growing at a steady clip. During the period between 1980 and 2001, U.S. oil consumption grew by some 20 percent while Asian demand exploded. With a population of 3.6 billion people, Asia has seen oil demand surge by two million barrels a day to 20 million barrels a day in the last year alone. China is by far the biggest consumer of oil in Asia and is now the second largest consuming nation after the U.S.

But what is driving Chinese demand? The love affair with the automobile for starters. Currently, China is home to some 20 million cars with analysts predicting that China could see between 120 and 145 million cars on their roads within the next fifteen years. As well, China has experienced a tremendous increase in the country's manufacturing base over the last few years. This has placed huge demands on the country's electric grid which is overtaxed at best. Enterprising businesses have solved the power shortage problem by buying diesel generators to power their factories, further driving up the demand for oil. With both a surge in car ownership and a rapid industrialization underway, China is redefining the worldwide supply/demand balance for oil. Not only is China an engine of growth, but India and other Asian nations are also experiencing rapid levels of economic growth which further increases the region's reliance on oil. By some estimates, Asia's demand for oil will double within the next 6 to 12 years.

Figure 1: Surging Oil Demand

Source: M. Murenbeeld & Associates

Not only is demand (consumption) on the rise, but supply is tight and getting tighter. Major oil discoveries are few and far between these days and historically prolific fields such as those in the North Sea and the Gulf of Mexico have already reached their production peak and have started to decline. As well, there hasn't been a major oil field (1,000,000 barrels/day) discovered in the world for more than 35 years. Many of the giant fields (reserves in the millions of barrels) are now some 50 to 70 years old. According to a study by Deustche Bank (published in the Financial Times - Sept. 22, 2004) only 6 percent of the world's 15 major oil companies (between 2001 to 2003) have been able to replace all of the oil that they have pumped. In fact, Deustche Bank estimates leading oil companies during the 2001-2003 period have actually cut exploration by some 27 percent.

The world's major oil fields are in decline. Demand is surging from a developing Asia coupled with increasing demand in Europe and North America. These two factors, combined with decades of under-investment in the oil industry, have resulted in the current situation. During the 1990's, oil hovered around the $20 per barrel mark and investors were enamored with technology stocks. During the 1990's, investors rewarded oil companies that cut expenditures and boosted dividends at the expense of companies that plowed their profits into the drill bit. The result? There developed an under-investment in the productive capacity to refine, transport and explore for oil and natural gas. There hasn't been a refinery built in the U.S. since 1976 and since 1982, the number of U.S. refineries has fallen from 321 to 149. As well, the number of rigs searching for oil in the U.S. has fallen from 4,530 rigs in 1981 to around 1,200 today. Today, the under-investment in production and refining capability seems extremely short sighted.

With a third of the world's supply and nearly half of the world's proven reserves in the hands of OPEC countries (a cartel that sets the marginal price of oil), we are heavily reliant on the Middle East and other areas of the world that have historically been politically unstable for a significant proportion of the world's oil supply. Many of these OPEC countries are characterized by a lack of freely elected representation. This, when combined with a rising population, a poorly diversified economic base and large numbers of unemployed youth raise the very real possibility of geopolitical turmoil in those countries that we are most reliant on for a ready supply of oil.

With a maximum productive capacity of maybe another 1 million barrels a day possible from OPEC and with demand continuing to surge it seems hard to fathom how prices for crude oil will have anywhere to go but up. Higher prices could ironically be the solution for the world's energy woes since they would go a long way towards curbing demand and allowing exploration activity and inventory numbers to build.

Many pundits are quick to point out that although the price of crude oil (from which gasoline is refined) is up sharply, it is nowhere near the inflation-adjusted highs struck in the 1980-1981 period. Critics also point out that we have lessened our dependence on oil over the decades from 7.2% of consumer expenditures (4.5% of GDP) during the 1980's to 5.3% of consumer expenditures (3.6% of GDP) today. While that is certainly true, we are nowhere near reducing our reliance on oil to fuel the modern world. We truck our goods around the country, commute to work and fly in aircraft not to mention our use of chemicals and plastics - all petroleum derivative products.

Figure 2: Crude Oil Prices Over Time

Source: M. Murenbeeld & Associates

According to the International Energy Agency, the Paris based watchdog, the oil industry will need to invest some $69 billion a year in exploration and production during the next decade to develop new sources of oil, adding to refinery capacity and building other infrastructure to meet world demand. This is a truly staggering number.

While economists may argue that demand will be curbed by higher prices, this is not necessarily a historical reality. During the 1970's, with the economies of the U.S., Europe and other countries in the tank, the price of oil rose 15 times. Eventually, the U.K. economy (the fifth largest economy at that time) went broke and had to be bailed out by the International Monetary Fund. Oil prices continued to rise during this period because, while demand was slowing, supply was extremely tight. Today, the situation is similar.

Investors looking to profit from the coming surge in oil prices should consider a well- diversified basket of energy producers. For the most part, Wall Street earnings estimate remain far too conservative with the average oil price imputed in the earnings forecast clocking in at $35 per barrel. With oil prices well north of $35 per barrel, earnings are likely to continue to surprise on the upside, which will further serve to place a floor under these investments.

Figure 3: Estimated Price/Gallon Needed to Curb Demand


StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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