Why Energy Investors Will Get Crushed If They Fail to Look Towards Dubai

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The way I see it, U.S. and European energy traders will be lucky if the door doesn't hit them in the backsides as everybody heads for the doors.

Like so many Western investors, they still have their blinders on.

They think that if demand in the U.S. and the European Union (EU) begins to slide that oil prices will fall into the toilet right along with it.

But what they don't see is that Asian oil demand is what actually "drives" the global oil market.
This is why today's investors need to adopt an energy investment strategy focused on what is happening on the other side of the Pacific.

Because what happens there is critical to higher prices and profits here.

Here's why.

First, consider Asian demand.

In the fourth quarter alone, Asian demand increased by 400,000 barrels per day even as consumption in the rest of the world fell by 700,000 barrels a day, according to the International Energy Agency (IEA).

Meanwhile, Chinese demand in particular is so strong that the Red Dragon is set to import more oil than the United States within two years, according to my projections.

And don't take my word for it. Goldman Sachs Group Inc. (NYSE: GS) thinks the U.S. will be overtaken by China this year, while the IEA believes it will happen in 2020.

I think that's splitting hairs frankly.

What matters is that Asian oil demand growth is likely to represent a staggering 70% of the world's total oil demand growth this year. Or more depending on which studies you believe.

US China Oil

As China Rises the World Shifts Toward Dubai

Second, consider the effect Asia has on how oil is priced.

U.S. investors have focused on U.S. and Brent oil prices for years, and with good reason. North American markets have been the largest in terms of both consumption and growth.

Now, however, Asia's demand growth of more than 720,000 barrels per day dwarfs our own.
By comparison, U.S. demand growth is only 310,000 barrels per day while Europe's demand growth is positively anemic at only 260,000 barrels per day, according to the IEA.

That means Dubai's Mercantile Exchange is rapidly becoming the new pricing standard -quickly displacing the traditional Brent.

That's where countries like China, Japan, Indonesia, Vietnam and others in the Asian Rim increasingly price their oil for delivery.

Sadly, most investors can't even find Dubai on a map, but they'd better learn in a hurry.

Today, the differential between Dubai crude and Brent crude is dropping quickly, and now stands at a 14-month low of $2.73 a barrel, according to the Financial Times. Last April the spread on the Dubai crude was 237% higher at $7.61 a barrel.

Critics note that this is because Dubai crude is of lower quality and the Libyan revolution left world markets without sweet crude.

True, but they're missing the point – Asian demand is shifting commodity pricing from London, New York and Chicago to Dubai, and even Shanghai, where traders believe it more accurately reflects regional pricing influences.

And as China's demand grows, prices head higher.

China Oil Demand

Emerging Markets: As Simple as Supply and Demand

Third, consider infrastructure development in the emerging markets.

China and India are both constructing new refineries estimated to have more than 1 million barrels a day of processing capacity between them.

Admittedly, bringing an additional 1 million barrels a day of production capacity on line doesn't sound like a lot in the scheme of things, especially when we've become numb to trillion-dollar deficits and bailouts. But think again.

The world consumes approximately 89.5 million barrels a day yet has production capacity of only 90 million barrels a day give or take.

This means the amount of production capacity being brought on line exceeds total current global excess production. It also means that the placement of that new capacity – in China and India – is likely to have a significant impact on global pricing.

Think about it. Supply and demand determines prices. It's one of the most basic of all economic principles.

If demand increases or there is a disruption in supply, there is upward pricing pressure. If demand falls relative to supply, prices drop.

By the same measure, if there is a limited supply and growing demand coupled with new capacity, pricing power shifts from markets where demand has dropped to markets where demand is rising.

You see this in your own neighborhood on a much smaller scale already.

If there are two service stations in town and a third one is built, customers start buying from the third station… particularly if it's closer to where they live, has more attractive prices, better gas, or is closer to the refineries servicing it.

Initially prices will drop in response to increased competition. But, over time, as the new entrant disrupts the existing supply and demand balance, prices actually tend to rise, particularly if the three service stations now have to fight over the same limited number of tankers serving the community.

Then there is the process of demand building to consider. New capacity arguably facilitates demand growth.

I think that's a battle that's already begun.

Take the Chinese government, for example. Beijing is likely to use its newly built refinery capacity to boost strategic reserves.

Many people believe this will be a function of China's growing military demand, but China's growing transport sector is far more important because it moves the goods needed by 1.3 billion people to market.

So they'll buy as much oil as it takes to prevent a revolution…even if it means we don't have any left to buy (except at exorbitantly high prices). This is why Chinese oil companies have been buying up oil assets anywhere they can get their hands them.

They know it's an issue of domestic survival rather than global domination, as the West prefers to think about their action.

At the same time, the so-called Arab Spring has interrupted the capital investments needed to maintain current oil production, shipping, and pricing levels.

This is significant because oil markets cannot function without constant capital improvement and investment, at least not at current prices.

Factor in the vulnerable oil transportation routes in the Gulf, the Malacca Straits and one can easily envision $150-$200 a barrel in risk premiums alone if things heat up…even without open hostilities.

More if the shooting starts.

How to Play the Global Shift from West to East

So now what?

No doubt the United States Oil Fund (NYSE: USO) and the United States Brent Oil Fund (NYSE: BNO), long the domain of both groups of traders will remain viable investments, but it's important to understand they're not the leaders they once were.

The same can be said for the big oil companies like Exxon Mobil (NYSE: XOM), Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) and even the vilified BP PLC (NYSE ADR: BP).

I think the far more interesting and potentially profitable game lies directly in Chinese oil companies like Sinopec (NYSE ADR: SHI), PetroChina (NYSE ADR: PTR) and CNOOC Ltd. (NYSE ADR: CEO). Not only do these companies have the global reach needed to capitalize on the demand shift, but they've got the cash, too.

I also tend to favor companies like Halliburton Co. (NYSE: HAL), which provide plenty of services to foreign oil companies and oil service providers. Not only are they quite literally in the middle of everything, but many times services companies like Halliburton can work for several competitors at once, further expanding their coffers and their earnings.

And finally, I think the Middle East's markets are incredibly beaten down and, next to the Chinese markets, probably the most hated on the planet at the moment.

That potentially makes financial and property-heavy choices like the Market Vector Gulf States (NYSE: MES) appealing because all that oil money has to flow somewhere.

Eventually.

Either way, it's time for western oil investors to take the blinders off.

[Editor's Note: To get all of Keith's latest trades click here. Keith's Geiger Index advisory service has notched 58 winners out of 60 total trades over the past three years - a success rate of 97%.]

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. Jeff Pluim | January 26, 2012

    I think Keith is missing some major points. Firstly, the northern route pipeline from Alberta to Kitimat, which will supply vast amounts of oil to Asia, will help to depress the price of oil – more supply, lower price. Secondly, and I believe more importantly, electric cars are going to enter the market in a big way. In the 1970's when GM leased a bunch of electric cars to a few people, those people did not want to give up their cars when the lease was over. Even though the technology for electric cars was no where near as efficient as it is today, people were even protesting back then to get their cars back. But GM took them all back and destroyed them. If you want an electric car right now, you have to go on a long waiting list. The demand is huge. Today's electric car technology is far superior to that of the 1970's. When you look at the curve of technologies, for instance the digital camera, you can see an amazing comparison. Kodak invented digital photography in the early 1980's but because they were making so much money selling film, they decided to shelve the technology. Now Kodak is struggling just to keep from going out of business. They could have been on the leading edge of that great business opportunity but their backward thinking caused them to screw-up. Like digital cameras, electric cars will dominate. Sure, there will still be a need for gasoline power, until the battery technology improves. But let's face it, most of us don't drive far enough on a daily basis to justify more than the limited range of current electric vehicles. Gas powered vehicles will soon go the way of the film operated camera, and the companies who manufacture the highest number of them will benefit the greatest. And since gas guzzling cars are the biggest users of oil products, the demand for oil will drop and so will the price of a barrel of oil.

  2. Ken | January 26, 2012

    Well Jeff,
    That electric car business sounds real good but where does electricity come from? Unless you know where there are some current bushes we can all plug our cars into we are still going to need fuel. Now I don't know if you have ever generated electricity or not. If you had you would know there is a serious flaw in your thinking. You will lose about 40-60% of your fuel into heat and friction. I know this because I live in the weeds in Alaska where we actually generate electricity. I hope you don't take this as an insult but you should really think all this through before you vote for any more liberals who also believe in current bushes and perpetual motion.

    • Jon | January 26, 2012

      To both Jeff and Ken,

      You both make valid points, but neither of you is right (or wrong for that matter). As an electrical engineer in the area of vehicle based alternative energy I think I can clarify a few things.

      1) Electric and other forms of alternative-energy vehicles are on the rise. However do not be confused: the world is still hiding in its pretty little "hybrid vehicle" world. That in turn causes the number of electric cars produced to be very small by comparison, which accounts for the large waiting list. What this effectively does is create an air of exclusivity around the current electric cars, especially the good ones like those made by companies like Telsa Motors. My projection is that demand and production for electric cars will pretty much stay where it is until it is recognized by the public that the other forms of alternative energy like hydrogen are not really worth investing in (for cars at least).

      2) To Ken, don't be too smug yet, there are two points that Jeff had on his side that you forgot to address: firstly, the majority of China's fuel comes from coal and they are moving towards more nuclear, but standing their ground on oil and gas. Secondly, it is MUCH more efficient to generate the power in a plant and then send it over wires than to generate the power in a car (unless we are talking transporting the electricity over thousands of miles…I don't think many Tibetans will be buying Teslas in the near future ;) ). You are very correct in pointing out the "where does the electricity come from?" argument, and the fact of the matter is these cars are effectively burning fuel because we plug them in. However, they are very efficient about it. Telsa sites the the Roadster S, their less-efficient, more-sporty car, averages at about 70-100 miles per gallon in the US where we burn oil and gas for electricity. That's good, but nothing Jetsons -worthy. In a heavily coal-dependent continent like Asia however, that number starts looking more like 500-600 miles per gallon + a pound or two of coal. But while we are just thinking about oil and not emissions, we can forget about the coal and simply look at the jaw-dropping effect that has on oil demand.

      All in all however, I think that oil will go up for one main reason: pre-established infrastructure and architecture. That is to say, the reason the US still consumes so much oil is because it works and its already established as an energy standard. Paradigm-breaking as not been the United States' forte since the Revolutionary War, not really at least. Japan has technology, Germany and Russia develop the best factories and war machines for the money, and now China is on the verge of taking the lead in business (which we didn't even have alone! we shared #1 in that with Great Britain!). As an engineer, I don't see any radical changes coming in the next 10 years to oil consumption except that it will continue to increase globally and the wells will continue to be depleted.

      In the energy world, hydrogen is naturally sparse because it is lighter than air and disproportionately difficult to synthesize, geothermal is very location specific, wind turbines are a good supplement but wouldn't cover our energy needs even if the world was coated in them, and solar is (at the moment) quite inefficient. Oil is king, and at the moment its only usurpers are coal, which the world hates (rightfully) because it dirties and poisons their air and land, and nuclear, which is a beautiful bit of science, but volatile, and expensive to clean up. Oil is comfortable on its throne, and I would say that going long on ANY of these companies above would be financially wise.

      Hope the insight is valued,

      Jon

  3. ray | January 26, 2012

    excellent,great job

  4. Brent | January 26, 2012

    Does not the analysis also support US domestic oil producers and Petrobas?

  5. Ryan | January 26, 2012

    Well Ken,
    There are three flaws in your thinking: 1) Internal combustion engines also lose similar amounts of energy to heat and friction; 2) electricity is mostly generated through burning NG (which is very plentiful right now) and of course can be and is generated from wind, geothermal and solar and 3) he did not claim to have voted for any liberals making you the ass in assume.

  6. Bryan | January 28, 2012

    I think that we as a nation worry about the wrong promblems, we live in a world were if someone says , coal is bad it kills the air, well that is what they go on. They don't produce the facts. We need to worry about getting the Obama situation under control and getting him out of office. Coal is the bet way to produce energy. If we would just check the facts, then we could see what is really happen, and china is more toward coal, I know I sell to them and invest with them. We need to worry about what the us is doing not every one else..

  7. Richard | January 31, 2012

    Nicely said Jon but don't rule out Natural gas as a new comer that will make a difference. Also todays Nuclear technology is far better than most know, they can now make portable reactors for small towns that will last 30 yrs. and at a price that makes it economical for remote areas. By the way someone really should investigate all those patents that the US Gov't has shelved "for national security reasons" over the years, technology is accelerating and a game changer probably already exists, however not everyone can pull a Zuckerberg and steal an idea.

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