How to Profit From the Oil-Price Spike of 2010

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Oil prices staged a remarkable rally this year on the back of a weak dollar and a nascent economic recovery. In 2010, it's likely that these same factors will combine with an increase in global energy demand to push oil prices back up over $100 a barrel.

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With stockpiles still high and energy demand rebounding sluggishly, most forecasts are calling for the "black gold" to edge up into the low-triple-digit price range. That's 40% higher than where oil is trading right now – but is still well below the record high of nearly $150 a barrel that was established in 2008.

Money Morning Chief Investment Strategist Keith Fitz-Gerald is even more bullish. He believes that a price of $100 a barrel is "easily attainable" and says that some sort of unforeseen market shock could cause crude oil to spike as high as $150 barrel by the end of 2010.

"Overall consumption is going up, not down, and the dollar is the other wrinkle. A weaker dollar generally means higher oil prices," Fitz-Gerald said. "But oil prices will surge next year not just because of the recovery, but because of a global macro event that could send prices soaring as high as $150 a barrel."

Investors who prepare for this possibility will have a shot at windfall profits. At the same time, however, consumers will feel the pinch.

Take pump prices. Rising crude prices will help boost the average retail price of regular-grade gasoline from $2.35 a gallon this year to $2.83 in 2010, and pump prices will approach $3 a gallon during next year's driving season, the U.S. Energy Information Administration predicted in a forecast report released earlier this month.

Utility bills will also increase, as heating oil and electricity prices escalate, the EIA and other forecasters say.

Conflicting Data

If investors are feeling whipsawed by oil-price forecasts that are bullish one day and bearish the next, that's not a surprise. The lack of uniformity in the forecasts is understandable – given the mountains of often-conflicting data analysts have to work with.

For instance, commercial-crude-oil storage among industrialized nations of the Organization for Economic Cooperation and Development (OECD) stands at about 60 days of demand. The Organization of Petroleum Exporting Countries (OPEC) has said 52 days of forward demand cover was reasonable.

What's more is that an estimated 90 million barrels of oil are being hoarded on seaborne tankers by speculators looking to profit from bigger long-term gains.

Of course, supply has been ample all year. But that hasn't stopped oil prices from rising for most of 2009. In fact, since hitting its low for the year – $34.03 a barrel – on Feb. 12, crude oil has zoomed 116%.

The weak U.S. dollar has sustained the oil bull to this point. The dollar has tumbled about 18% against the euro since Feb. 12, and the Dollar Index – which measures the dollar against a basket of currencies – has slid more than 8% this year.

And going into 2010, the dollar will likely continue on its downward course.

The Downtrodden Dollar

The expansive monetary policy pursued by the U.S. Federal Reserve over the past two years has sucked the life out of the greenback.

The Fed has pumped in excess of $2 trillion into the U.S. economy since the financial crisis began more than two years ago. It has lowered its benchmark federal funds rate to a record-low range of 0.0% to 0.25% and has stepped up purchases of U.S. Treasuries and mortgage-backed securities.

Monetary Base Chart
As its most recent meeting concluded Dec. 16 Fed Chairman Ben S. Bernanke said the fragility of the U.S. recovery demands that interest rates be kept low for "an extended period" of time.

"With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the committee expects that inflation will remain subdued for some time," Fed policymakers said.

Unfortunately, the Fed will soon discover, expectations may not match up with reality.

With the dollar in a nosedive and its prospects for a turnaround dim, investors are fleeing the currency and taking refuge in hard assets.

"The dollar is the single most important factor in the market," Eugen Weinberg, senior commodities analyst at Commerzbank AG (OTC ADR: CRZBY), told Bloomberg News. "It's not the fundamentals. The weaker dollar is a really big concern for many investors and they try to protect themselves by buying into commodities."

Indeed, commodities prices across the board have soared in response to the dollar's decline. Gold futures have added 38% this year and could climb as high as $2,000 an ounce next year. Silver prices have jumped, as well, and are at their highest level since July 2008 at about $20 an ounce.

Industrial materials – bolstered by stronger-than-expected economic growth, particularly in China – have also seen increased investor demand. Aluminum prices have surged more than 60% since March, when the global rally in stocks began, and copper prices are up more than 70%.

"There is security in hard assets … the U.S. economy and the dollar aren't looking too pretty," Kimberly Tara, chief executive at fund manager FourWinds Capita Management, told Reuters. "It is clear that the ability of the dollar to rally in the near future is extremely limited and that does impact where investors want to put their money."

Economic Growth Accelerates, But Oil Production Stagnates

While the dollar is poised to carry on its decline, the global economic recovery is picking up steam.

The OECD, in its most recent economic outlook released in November, more than doubled its 2010 forecast for developed nations, saying that strong growth in Asia – particularly China – would help pull the "more feeble" West out of its financial malaise.

After predicting in June that the combined economy of its 30-member nations would grow 0.7% in 2010, the OECD raised its forecast for developed economies, projecting growth of 1.9% next year and 2.5% in 2011. Economic output will contract by 3.5% this year.

"We now have the numbers that support a recovery in motion," Jorgen Elmeskov, the OECD's acting chief economist, told Bloomberg. "It's still a slow recovery because of considerable headwinds from the need to adjust the balance sheets of households, enterprises and financial sectors."

While pointing to China as the main catalyst for a global rebound, the OECD also cautioned that the recovery in developed nations remains fragile.

"The upturn in the major non-OECD economies, especially in Asia and particularly China, is now a well-established source of strength for the more feeble OECD recovery," said the OECD, whose only two Asian members are Japan and South Korea.

U.S. gross domestic product (GDP) should expand by 2.5% in 2010 and Eurozone growth will accelerate to 0.9%, the group said. In June, the OECD had projected 0.9% growth for the United States and flat growth for the Eurozone. The OECD said Japan should expect GDP growth of 1.8% in 2010, instead of earlier forecasts of 0.7% growth.

By contrast, China's economic output is projected to expand at a10.2% rate in the new year.

The OECD also released its first 2011 forecasts, suggesting 2.8% growth for the United States, 1.7% growth for the Eurozone, 2% growth for Japan, and 9.3% growth for China.

As economic growth rebounds, so, too, should oil demand. The International Energy Agency (IEA), the oil watchdog for the West, forecasts a sharp pickup in oil demand in 2010, up 1.5 million barrels per day (bpd) from this year's level.

OPEC is more restrained in its forecast, but believes consumption will increase by 800,000 bpd in 2010. That's only about half the increase predicted by the IEA. But that isn't necessarily bad for oil prices: It will enable OPEC to keep a lid on production.

During the precipitous price decline that oil experienced from 2008 to 2009, OPEC – supplier of 40% of the world's oil – issued three production cuts totaling 4.2 million bpd, an amount equal to almost 12% of its capacity. Despite some foot-dragging from Iran and Venezuela – two countries that rely heavily on oil revenue to fund massive social programs – OPEC has gotten an uncharacteristically high rate of compliance.

Last month, OPEC pumped about 2 million bpd less than it did a year ago.

"With global demand growing and OPEC holding production flat, stockpiles are going to come down, and that's bullish for prices," Mike Wittner, the head of oil market research at Societe Generale SA (OTC ADR: SCGLY) told Bloomberg.

Wittner, an energy analyst at the U.S. Central Intelligence Agency (CIA) during the 1980s and the IEA in Paris between 1997 and 2002, said purchases by hedge funds and investors seeking protection from inflation will support prices.

"In contrast to some other banks, we acknowledge quite openly, and believe, that non-fundamental factors do play a role in setting oil prices," he said.

Oil prices will end 2010 near $88 a barrel, according to Wittner. But some analysts are more optimistic.

Technical analyst Richard Ross, head of global technical strategy for Auerbach Grayson, told Forbes that the price of crude oil will trend upward to $85, then $90, settling in at as much as $103 per barrel by next summer.

Ross noted that prices of $103 a barrel would represent a 61.8% retracement of the entire bear market decline in oil, and as such, serves as a vital statistical indicator for traders and analysts.

But each of these price scenarios is based on conventional supply-and-demand scenarios. What happens if there's an unexpected "shock" to the global energy economy, asks Fitz-Gerald, the Money Morning chief investment strategist who also the author of the best-selling investing book, "Fiscal Hangover."

For instance, Iranian troops last week entered southern Iraqi territory and temporarily took control of the al-Fakkah oil field. They left the field within days of the incursion, but the incident should serve as a stark reminder to investors that oil production is still vulnerable to political instability in the Middle East. And it's highly unlikely that 2010 will pass without incident.

"Don't think for a minute that was casual," said Fitz-Gerald. "It was a highly provocative move designed to see what the U.S. response would be."

An incident such as that could be enough to send oil prices back up to the record level of $150 a barrel, he said.

Profiting From the 2010 Oil Spike

Many companies benefit from high oil prices, but one of the best plays this year could be U.S. oil major ExxonMobil Inc. (NYSE: XOM).

A recent cover story in Barron's called Exxon the Goldman Sachs Group Inc. (NYSE: GS) of the energy business, except "Exxon out-Goldmans Goldman."

"Like Goldman, Exxon has a distinctive ‘best-and-brightest' corporate culture, and relentlessly focuses on return on investment and efficiencies at the expense of egos," Barron's said.

Indeed, with a world-leading market capitalization of $325 billion, Exxon isn't hiding from anyone. However, the company that set a world record with $45 billion in after-tax profit in 2008 has underperformed this year.

While oil prices have surged 60% since Jan. 1, shares of Exxon have dropped more 14%. Its peer companies have seen their shares advance by more than 33% during that same period.

The company is currently trading at 16 times earnings – a bit below the industry-average Price/Earnings (P/E) ratio of 17.5.

The consensus estimate for 2010 is for the company to earn nearly $6 a share. At current valuations, that projects a price of $96. Were the company to deliver on the projected $5.95 a share in 2010 earnings – and to trade at the industry multiple of 17.5 – Exxon shares would trade at more than $100 each. That would represent a 48% return from yesterday's (Monday's) closing price of $68.51.

No matter which valuation is used, it's pretty clear that Exxon's shares have some room to run.

The energy giant had proved nearly 23 billion barrels of oil and natural gas at the end of 2008. Its total energy resources – proven reserves as well as deposits that don't yet qualify as proven – are the equivalent to 72 billion barrels of oil and gas. Exxon has improved its competitive position with its proposed purchase of XTO Energy Inc. (NYSE: XTO), the largest U.S. natural gas producer, in an all-stock deal valued at $31 billion. The buyout is to close in the second quarter of the new year.

The XTO purchase will give Exxon the equivalent of about 45 trillion cubic feet of natural gas throughout the United States and puts the world's largest publicly traded oil company in prime position to expand in shale gas, the fastest growing area in the natural gas sector.

Since 1977, Exxon has returned 15% annually, including reinvested dividends, versus 11% for the Standard & Poor's 500 Index, Barron's reported. The company's dividend has doubled in the past 10 years, and could increase by another 5% or more this year, according to the magazine.

Money Morning's Fitz-Gerald suggests that investors focus on operators of oil transit systems such as pipelines and shipping. These companies stand to make profit transporting oil and gas almost regardless of their price.

For instance, on Feb. 12, Fitz-Gerald recommended Kinder Morgan Energy Partners LP (NYSE: KMP) to subscribers of Money Morning's sister publication, The Money Map Report. Kinder Morgan is one the largest pipeline operators in the United States. Its stock has jumped 35.92% since Fitz-Gerald's recommendation. (Click here for more information on stocks in the Money Map portfolio.)

A riskier play might include a look at Petroleo Brasileiro SA (NYSE ADR: PBR), more commonly known as Petrobras. Petrobras has made headlines with the massive discoveries made off its coast in recent years. While deep-water fields like these are costly to develop, they may see a lot of attention if oil prices make another run.

For a more direct play on oil prices, you might also try an exchange-traded fund (ETF), such as the United States Oil Fund LP (NYSE: USO) or the iPath S&P GSCI Crude Oil Total Return Fund (NYSE: OIL).

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