A Second Chance To Capture Oil Profits

Published: December 15, 2008

Curiously, the best time to get in early on a powerful investment theme is when almost nobody is talking about it -- except in disparaging tones. That being the case, the contrarian in me is beginning to think that now might be a great time to start thinking about oil-related stocks.

Just to review, oil prices were closing in on $150 per barrel this past summer and analysts had nothing but glowing things to say. In fact, many were projecting prices to slice right through $200 per barrel. Of course, those forecasts proved to be wildly off the mark.

As you probably know, oil prices have tumbled precipitously since then and sank back below $50 per barrel. So of course, analysts are now roundly pessimistic and beating the drum for further declines -- with some expecting prices to slide back towards $25 per barrel. (Remarkably, crude prices spiked $25 in one day back in late September as short sellers rushed to cover their positions.)

But just as the pendulum carried too far to the high side as optimism peaked, it has now swung too far to the low.

It's far too simplistic to say that oil has lost two-thirds of its value so it has to rebound sharply. After all, the world looks quite a bit different today than it did back in July. The U.S. dollar has appreciated against many foreign currencies, taking the wind out of the sails of dollar-denominated commodities. At the same time, hedge funds have been unwinding energy-related positions en masse.

Perhaps most importantly, a slowing global economy has put the breaks on demand. Regular reports from the Energy Information Administration show that oil stockpiles continue to build -- last week, inventories grew by 7.3 million barrels, versus expectations of just 400,000. Against this backdrop, oil prices deserved to pull back from their unsustainable highs. But as is usually the case, the selling has become overzealous and should pave the way for a nice rally as prices stabilize at more of an equilibrium point.

What happens over the next few weeks is anybody's guess -- ask ten different experts and you'll get ten different forecasts. There are too many unpredictable variables in the equation. Last month, crude prices jumped almost +10% on the government's bailout of Citigroup, something that had nothing at all to do with oil. But over time, supply and demand forces will win out -- and the fundamentals point unmistakably towards higher prices.

From a big picture perspective, worldwide oil consumption marches slowly but inexorably higher each year -- from 63 million barrels of oil per day in 1980 to around 85 million currently.

We need that oil for a multitude of uses, from residential heating to industrial applications to transportation fuel. And while the alternative energy movement may gradually eat into demand, it won't stop the tide. That's particularly true in industrializing nations like China, which could one day be the world's biggest oil consumer, or in India, where imports could triple over the next decade.

Overall, the International Energy Administration (IAE) is forecasting that global demand will reach 98 million barrels of oil each and every day by 2015. So despite a few hiccups brought on by temporary conditions, demand for oil is not going away.

As for the supply side, depressed prices act as a disincentive to production. The vast majority of the world's oil reserves (about 80%) are in the hands of nationalized oil companies owned by countries like Saudi Arabia and Venezuela. And if oil prices remain too low, they can always pull back on the production throttle and slash their output.

Recently, the Organization of Petroleum Exporting Countries (OPEC), which supplies about 40% of the world's oil, announced plans to cut production by 1.5 million barrels per day -- and even deeper cuts may be on the horizon. Others like Russia have also indicated plans to join in and slow production.

Meanwhile, keep in mind that most of the easy oil was dug up long ago and exploration companies are now having to dig in harsh conditions deep under the ocean for new discoveries. That means that marginal cost of production is rising, and projects that looked profitable at $150 per barrel aren't quite as promising today. So don’t be surprised to see producers sitting on their finds rather than tapping into them at today's reduced prices.

Exxon Mobil (NYSE: XOM) is one of many firms that has already delayed or cancelled certain expansion projects. Around the world, billions in new exploration could be put on hold. And with OPEC and others pulling over a million barrels a day off the assembly line, it might not be long before available supplies are choked off. And keep in mind, just a few months ago fears of a global shortfall ran high -- even at triple-digit prices with producers running full steam ahead.

So reduced production levels might be fine today, but what happens tomorrow when the global economy is back on track and demand picks back up. Former Department of Energy Secretary Spencer Abraham has had similar thoughts, pointing out that "macroeconomic conditions have lowered oil prices for the moment, but there is nothing in the underlying economic picture that suggests this slowdown will be long-lived."

With all this in mind, Half-Priced Stocks editor, Nathan Slaughter, sees plenty of ways that investors can profit from an expected rebound in oil prices. In fact, recent issues of his Half-Priced Stocks newsletter have been heavily weighted with oil-related picks, from deepwater drillers like Transocean (NYSE: RIG) to drilling equipment firms such as National Oilwell Varco (NYSE: NOV).

One of his favorite new ideas, though, is an integrated oil company with operations in oil-rich regions from Alaska to Libya. Last year, the company spit out 854 million barrels of oil -- and it has 10.6 billion barrels of reserves still waiting underground. Over the past three months alone, the firm has raked in enough cash to repurchase $2.5 billion worth of stock, dish out $700 million in dividend distributions, and still have over $4 billion left over to upgrade facilities and expand exploration activity.

But here's the great part. Even if oil prices remain weak, the company will still churn out mountains of profits and dish out generous dividend distributions. In fact, it banked over $12 billion in profits last year by selling oil at an average price of around $65 per barrel (with an average production cost of just $7.21 per barrel).

To read Nathan's in-depth profile of this promising company and learn more about Half-Priced Stocks, please visit this link.

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