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The miracle fuel — the investor’s guide to oil prices

The demand for oil will just keep on growing, says this Canadian analyst, and produce good buys for investors, like two U.S. firms.

Maybe there should be an Oil Channel on TV. We could get constant updates on the prices of West Texas Intermediate, Brent Blend and Dubai crude, panel discussions on the political machinations of OPEC or Peak Oil Theory, and eyewitness reports on new discoveries around the globe.

All oil all the time.

The fact is, you cannot exaggerate the importance of oil, Mr. John Stephenson writes in the latest edition of The MoneyLetter. We see the rising value of energy every day at the gas pumps, but that’s just one expensive drop in the bucket of the worldwide thirst for oil.

Mr. Stephenson, a portfolio manager at First Asset Funds and a frequent visitor to business TV, sees no reason to expect oil prices to fall. He also claims that two U.S. oil stocks are better buys right now than most Canadian producers. We’ll find out why shortly.

Cheaper than coffee or orange juice

Mr. Stephenson puts the case starkly. “In the past five years, crude oil prices are up fourfold, and if you believe the advice of some leading investment strategists, they are set to double again.”

Think about it. Five years ago the price of crude hovered around $25 to $30 dollars a barrel. Three years ago, it “broke the barrier” of $60 a barrel. This morning it stood at $125.80 a barrel.

The rise in price has brought the inevitable “howls of protest,” says the analyst, and the U.S. Congress has promised to slap a tax on the oil companies’ windfall profits. But the hue and cry over oil prices can’t obscure one overwhelming fact.

Oil literally fuels the modern world we live in. We rely on it for transportation, comfort and commerce. It “truly is a miracle fuel,” says the analyst. “Yet, in spite of its usefulness in a whole host of applications, it costs less on a volumetric basis than either coffee or orange juice.”

But it’s not just a convenience. It’s a strategic imperative for the nations of the world. “Fail to secure reliable and cheap sources of oil, and you are risking massive protests or rioting from your citizens.”

Still, as important as oil is, there’s a notion that speculators are pushing the price to new heights. Not so, says this analyst.

Woefully unprepared

Supply and demand plays a far bigger role in the rise of crude than “greedy hedge funds in Connecticut and New York,” Mr. Stephenson writes.

The gap between supply and demand is bound to grow, he adds. Since 2000, 83 per cent of the growth in the demand for oil has come from the emerging economies of Asia. “With hundreds of millions of potential new customers, the global oil industry seems woefully unprepared to deal with this new demand.”

Take India. Tata Motors Ltd. is about to put its new Nano car on the market at a sticker price of only US$2,500. That means more drivers and a spiralling demand for gasoline.

Take China. Right now, consumption of oil in the developed world is 25 barrels a year per person (did you know you were using that much?). In China, it is just 2.5 barrels per person per year. It will be going up.

Even if China’s growth rate slows from 11 per cent per year to 7 per cent, per capita consumption would increase from 2.5 barrels a year to 4 over the next decade. That would increase global demand for oil by 8 million barrels a day. At the moment, we have no more than 1 million barrels of spare supply available.

Where can we get more?

Production is stagnant

As rich as the big oil companies may be, they’re not adding new reserves fast enough to keep up. The traditional oil fields of North America, the North Sea and Mexico are turning out less. Thus even the integrated giants need to pour more money into exploration.

In the two-pronged world of oil, the nations that don’t belong to the Organization of Oil Producing Countries (OPEC) are producing less, but the OPEC countries aren’t producing enough to make up the shortfall.

World oil production has basically stagnated at 85 million barrels a day. The daily demand is 86.9 billion barrels a day. The gap is made up from depleting oil inventories and natural gas liquids like propane and butane — which won’t keep your car on the highway.

Cue the oil sands. Lighter, high-quality oil (which has little or no sulphur) is disappearing, as the three fields in Saudi Arabia that have been producing it dry up. That means unconventional sources, like Alberta’s oil sands, must be exploited, no matter how expensive they prove to be.

An aggressive buyer

In the midst of this growing need, oil stocks should be out of sight. But they’re not. It is “staggering,” says Mr. Stephenson, “that in spite of the obvious fundamentals underpinning the case for higher, rather than lower future oil prices, the stock valuations of oil companies do not reflect these fundamentals.”

When you compare price/earnings ratios on the S&P 500 Index, the companies with the cheapest valuations are the integrated oil companies!

The analyst lays down a strategy for MoneyLetter readers. “For my money, I would be an aggressive buyer of oil companies that have their oil reserves in geopolitically stable parts of the world. While costs have risen, valuations remain modest and the increasing scarcity of crude oil in the face of surging demand suggests that earnings or multiples, or both, for oil companies need to go higher.”

It’s the surge in costs that leads Mr. Stephenson to prefer two U.S. stocks now. The rising loonie has cut into the profitability of Canadian producers (since oil is priced in U.S. dollars). That’s not true of U.S. firms that measure both revenue and costs in greenbacks.

Among U.S. firms, Occidental Petroleum (NYSE-OXY) should be a winner in the months to come, the analyst believes. With 77 per cent of its production in oil rather than natural gas and valuations below its peers, “this stock looks cheap and should be bought.” It opened today at $90.70.

Hess Corp. (NYSE-HES) gets top marks for its much-needed exploration capacities. “Armed with an industry-leading exploration profile, a strong record of exploration success and a quality management team, this stock should advance in the months to come,” Mr. Stephenson tells his readers in The MoneyLetter. It’s not inexpensive, at an opening price of $117.85, but it is certainly trending upward.

So the “miracle fuel” may cost us more at the gas pumps and elsewhere for quite some time. But investing in the right oil stocks may just give us the miraculous profits to pay for it.