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Grandich Letter Special Alert

OIL - Is the Party Over Or Has It Just Begun?

by Peter Grandich
August 5th, 2005

I’m always amazed how the “Don’t Worry, Be Happy” crowd is able to spin just about everything to its favor. Less than two years ago, the Pied Pipers of Wall Street spoke often of how “cheap” oil was relative to where it has been in past economic cycles. Their forecasting models used an oil price from $25 to $35. Despite oil almost doubling, they managed to “spin” the rise by stating how well the economy has managed to perform in spite of the increase (judgment day is coming, thanks to an evolving debt crisis) and embraced higher oil by pushing... oops, recommending oilrelated stocks.

The fact is that oil is used in many, many more products than those most commonly though of -- like heating and gasoline. The money that went into paying higher energy costs versus into discretionary items and/or savings was a net negative, not positive. But thanks to tremendous strength in the energy stocks, the stock market (especially in Canada) was not punished. But, have no fear - a beating is coming thanks to America’s desire to live way beyond its means (more on that in our next Blue Chip & Income Report).

Realizing that oil is indeed one of the most influencing factors in our daily economic lives, the future price of the commodity is of great importance to everyone. Lets then take a look at the bullish and bearish argument for the future direction of oil prices:

Bullish argument:

• Supply – Like any commodity, oil’s most important single factor is supply versus demand. On the supply side, concerns about disruptions have plagued the market since December 2002 when a Venezuelan oil workers’ strike caused about a 500,000 barrels a day loss of crude production. Since then, refinery interruptions, weather concerns and terrorism disruptions have all impacted the supply side.

• Hubbert’s Peak - The Hubbert peak theory, also known as peak oil, is an influential theory concerning the long-term rate of conventional oil (and other fossil fuel) extraction and depletion. It predicts that future world oil production will reach a peak and then rapidly decline. The actual peak year will only be known after it has passed. Based on available production data, proponents have predicted the peak year to be 1989, 1995, 1995-2000. Or, according to the Association For The Peak Oil And Gas, it will be 2007 for oil and somewhat later for natural gas. This may lead to major economic consequences for the world since modern civilization is dependent upon cheap and abundant fossil fuels, especially for transportation, food production, chemical industrial processes, water treatment, home heating and power generation. The Hubbert peak theory is named for geophysicist M. King Hubbert, who correctly predicted the peak of U.S. oil production fifteen years in advance. While controversial, the theory increasingly influences policy makers within government and the oil industry. The current debate is rarely about whether there will be a peak, but rather when it will occur and the severity of the postpeak effects. Even the most generous mainstream reports estimate petroleum reserves lasting no more than 100 years.

Bearish Argument:

• Supply concerns overblown – Commercial crude-oil inventories are nearly 8% higher than a year ago, while world demand has slowed to a projected 2.2% this year from 3.4% in 2004, yet oil prices are 60% higher than they were a year ago.

• The U.S. government has basically stopped stockpiling emergency oil reserves.

• China’s thirst for commodities may be slowing when it comes to oil consumption. According to the latest from the International Energy Agency, China’s overall oil use declined 1% in the second quarter from the quarter a year earlier. China’s consumption had grown 11% in 2003 and 15.4% in 2004.

My Argument:

The world still has lots of oil, but to get at it will take time, mucho dollars and is located in hostile places that aren’t easy to get at and/or work in. While places like the Canadian oilsands can have a huge impact on the supply side, obtaining it it will be no easy task. The fact that several countries with major production are not big fans of the U.S. is not a plus for the supply side either.

So one would have to conclude that the least resistance to prices is up, no? Well, certainly the oil market has concluded that so far and anyone who has tried to guess the top has been proven wrong (or at least too early). Momentum is tough to break and with hedgefunds a dominate player in the oil market these days, it appears something big is going to have to happen to reverse the upside pressure.

I believe we are past the point of making energy-related investments over-weighted in ones portfolio. In fact, being a net seller going forward is a contrarian’s delight at this time. Yes, we can see $65 or even $70 oil. But, come 2006, we’ll likely to see below $50 and maybe even low $40s as the average price.

Why? Demand is likely to lessen as a softening world economy unfolds into 2006. Longerterm increased supplies can enter the picture thanks to new fields in Nigeria, Iran, Iraq and elsewhere (not to mention more wells drilled in new and existing fields in Saudi Arabia). New technology and software can boost recovery from known fields. And higher prices have now made it increasingly profitable to drill for such unconventional sources.

Peter Grandich
August 5th, 2005
grandich.com

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