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Markets: That Great Sucking Sound!
New York: April 28, 2008
By John R. Stephenson

What goes up must come down, or so we've been taught. But for oil prices, the direction seems to be up, up, and away. So what gives? Is it all speculative activity that is driving the price towards $120 per barrel and beyond? Or is it something more fundamental? For my money, it is all about supply and demand, and with supply struggling and demand surging — drivers will soon be shelling out even more at the pump.

But, in spite of calls from many prominent market strategists for higher oil and gasoline prices, there still is no lineup to buy energy stocks. Perhaps it's the collective wisdom of the market that oil prices can't possibly stay high for much longer. So who's right?

The debate has been raging on for decades. For some, lower oil prices seem to be the obvious conclusion. Technology, they argue, has always provided a solution to what ails the energy industry and high prices speed the discovery and production of incremental oil. With high prices and record profits, oil companies will innovate and eventually bring on more production, which will cause the system to fall into balance with lower oil prices.

Yet, oil companies are not biotech or technology companies and the much-touted technological solutions may never materialize. The reason? Major oil companies spend, on average, just four percent of revenues on research and development. A tiny fraction when compared with the 40 percent or so that biotech firms spend in a given year. So don't be looking for a technological breakthrough in the oil patch anytime soon!

The reason why oil prices are likely to stay where they are, or move higher, is that supply continues to struggle, while demand continues to soar. For some, weaker economic activity in the United States will result in slipping demand for crude oil. No doubt, this has historically been the case, yet today, much of the growth in demand for oil is coming from the countries that produce oil rather than those that consume it.

Throughout much of the producing world, low oil prices are a political weapon to keep the populace and the opposition in check. In Venezuela, gasoline costs a meager 25-cents a gallon and in Saudi Arabia, Kuwait and Iran it costs just 50-60-cents per gallon. With heavily subsidized prices in the producing regions, the result has been predictable — demand has soared.

Figure 1: Oil Consumption has Surged in Key Oil-Exporting Countries

Source: IEA, Joint Oil Data Initiative

Adding fuel to the fire, has been the surging economies of India and China, where rising levels of wealth has resulted in more drivers. The big impediment for getting drivers on the road is not the cost of a fill-up, but rather the price of a new car. But that's about to change as a flood of cheap cars such as the US$2,500 Nano car from Tata Motors of India, is getting ready to hit dealerships later this year. Millions of new households will soon have their very own straws to start sucking at the world's rapidly shrinking oil supplies.

Making matters worse is the struggling supply. For decades, the countries outside of OPEC (Organization of Petroleum Exporting Countries) have been bridging the gap between the increases in demand and supply. But supply growth in the countries outside of OPEC has been falling for a while, making us more reliant on production from OPEC. With surging demand at home, OPEC countries such as Saudi Arabia and Iran may be in no position to raise production dramatically. And that's a problem.

Figure 2: Non-OPEC Supply has been Struggling

Source: International Energy Agency, BMO Capital Markets

What makes matters worse is that production growth seems to be increasingly coming from natural gas liquids. The International Energy Agency ("IEA") continues to peg current oil production at 86 million barrels a day. But look behind that number and you will discover that over 9% of that daily production figure is not oil, but rather, natural gas liquids. Natural gas liquids ("NGL's) such as propane and butane are valuable hydrocarbons, however, the problem is that they are more suited to firing up your barbeque or lighter than fueling your car. While propane is used as a transportation fuel, it is used in less than 2% of all cars worldwide.

Unfortunately for drivers, the ratio of natural gas liquids to total "oil" has been rising steadily, with no end in sight. One reason why the proportion of NGLs is likely to increase is that the world's major oil fields are aging. With accelerated aging, the natural pressure in the oil reservoir declines, releasing more and more trapped gas or NGLs from these fields. This phenomenon, coupled with the fact that there hasn't been a major new oil field discovered in over 35 years, is putting us on a collision course for higher, rather than lower, oil prices. NGLs, while useful, cannot be used to meet the world's growing need for gasoline, diesel or jet fuels. Over 90% of demand growth and half of the world's "oil" usage is for transportation. This means that oil, and only oil, is what the world is craving, for its fix.

Russia's resource minister has already signaled that Russian production will likely decline. So far this year, Russian production is already down 1 percent. In Mexico, the situation is much worse as its massive Cantarell field is expected to see sharp production declines, effectively shunting Mexican export growth. And that's bad news for Americans, who import approximately 1.5 million barrels/day of oil from Mexico.

With conventional oil production (high volume, pressurized and light oil) in decline globally, oil companies have been forced to consider unconventional oil sources. Canada's oil sands, shale oil and other solutions are actively under development as a hungry world is demanding more and more oil. The problem with unconventional oil is that while there may be plenty of it around, the cost of developing it and upgrading it, is high, effectively putting a floor under the price of crude oil globally.

Investors looking to profit from crude oil's rise, should consider buying shares in companies that discover and refine this miracle fuel. While oil prices have surged, the price of the companies that explore for this precious resource have lagged the market. Clearly, oil prices need to drop or the shares in companies that produce this precious resource need to surge rather than slump. With more and more consumers globally sucking at dwindling oil reserves, the likelihood is that oil prices will continue to move higher, rather than lower, in the years to come.

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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