Outlook 2008: How to Profit When Oil Bubbles Up Above the $100 Level

Editor's Note: This is the Second Installment of an Ongoing Series Addressing the Outlook for Investment Opportunities and the Global Economy in 2008.

By Jason Simpkins
Associate Editor

The price of oil has climbed nearly 50% this year, a rise that culminated on Nov. 21 when the "black gold" hit a record high of $99.29 a barrel. After achieving that peak, crude prices gradually receded to the mid-$80 range. But now that crude has taken a breather from its rampant run-up, it looks as though oil prices are on the march again, and many analysts expect it to break the psychologically important $100 a barrel threshold early in 2008.

"We think $100 per barrel oil is on the horizon in 2008, perhaps in the spring," Brian Hicks, co-manager of the Global Resources Fund, told MarketWatch.com. "Ourforecast [calls for] an average oil price around $80-$85, up from about an average of $70 in 2007."

Hicks isn't alone. Approximately 54% of 150 commodity investors surveyed by Barclays PLC (BCS) expect the average price of oil to eclipse the $100 level over the next five years. The Energy Information Administration (EIA) - the U.S. Department of Energy unit that provides energy forecasts to policymakers - has also boosted its forecast for the average price of oil to $84.93 for 2008, up from its prior prediction of $80.

"Expectations that tight market conditions will persist into 2008 are keeping oil prices high," the EIA said in its latest short-term outlook report.

"Despite the OPEC (Organization of Petroleum Exporting Countries) decision… to hold production quotas steady and [despite] downward revisions to projected consumption growth in 2008, the oil balance outlook remains characterized by rising consumption, modest growth in non-OPEC supply, fairly low surplus capacity, and continued risks to supply disruptions in a number of major oil producing nations," the statement went on.

The Paris-based International Energy Agency, or IEA - advisor to 27 industrialized nations, including the United States - sees demand rising by 2.1 million barrels per day next year, an increase of 200,000 barrels per day from its previous forecast. The IEA has also warned of a "supply crunch" coming within the next five years. Despite increased demand, OPEC has so far refused to increase supply.

"OPEC has grown accustomed to higher oil prices, particularly in the face of the falling dollar," said Hicks, the Global Resources fund manager. "OPEC will likely keep production back because we still have not seen meaningful demand destruction from higher prices."

However, few analysts attribute oil's current lofty prices on the fundamental laws of supply and demand alone. Instead, most say that oil's dramatic price climb has been supported by a weak dollar and unfettered investor speculation. 

Bubble, Bubble, Toil and Trouble

The U.S. dollar is in a freefall: The greenback has dropped 20% against a basket of major currencies this year, and has plunged 44% against the euro since 2000. The euro has gained 7% on the greenback in the past four months alone. And as the value of the dollar has dropped, oil - which is priced in dollars - has soared.

"It's the dollar's weakness that has pushed prices higher here," Tom Bentz of BNP Paribas Commodity Futures, told Reuters.

As noted earlier, investor speculation is another key culprit in the escalation of oil prices. When speculators who are betting oil prices will rise hold a lot of futures contracts, the futures price escalates in a kind of self-fulfilling prophecy.

 "It's almost like magnetism. It draws prices to that level," said Adam Sieminski, an oil economist for Deutsche Bank AG (DB).

And those magnetic forces are still at work, according to an industry insider.

"We haven't seen the last shot above $90 because there are a lot of people betting on $100 oil," Starsupply Petroleum broker Justin Fohsz told Business Day.

Part of the reason so many speculative investors are attracted to oil is that it traditionally has been a volatile investment. Indeed, it can fluctuate wildly - over a month, a week, a day, or even an hour. In this situation, volatility equates to profit opportunities.

"It's a weak dollar, it's a strong global economy, it's China growing quickly at 13%," Eric Bolling, an independent trader at the New York Mercantile Exchange, told MarketWatch.com.

Bolling sees oil ranging from $60 to $120 a barrel next year, with the potential for price spikes that could take crude oil up to $130 or more a barrel - should there be a natural catastrophe like a major hurricane or tropical storm, continued economic fallout from the subprime mortgage crisis, or a political controversy or scandal.

"Oil is going to be very volatile," Bolling said. "It's an election year [and we're looking at] a possible recession."

However, many analysts don't view the recent swings in oil prices as a typical market gyration. They fear that oil prices cannot be sustained at this high level, and that a crash is imminent.

"It just seems that the market is [in spasm] here," Adam Robinson, an oil analyst at Lehman Brothers Holdings Inc. (LEH) told the Washington Post. "If slowly declining petroleum inventories start to build again, the radical increase we've seen to the upside can repeat on the way down." 

Atlantic Monthly Editor Clive Crook, who is also a columnist for National Journal, and a commentator for the Financial Times, also thinks that oil prices are due for a correction.

"Financial bubbles often do not burst until the last skeptics - the ones who called them bubbles early on, and [then] rolled their eyes as speculation raged - have capitulated to the mania and bought in," he said last month. "When even the people who were worried about $40 oil have stopped worrying about $100 oil, it may be time to panic."

Kyle Cooper, research director at IAF Advisors in Houston, agreed that the bubble will burst, but concedes that he doesn't know precisely when that will happen.

"What I don't know is if it will be here at $100, or [later at] $120," Cooper said.

Money Morning Investment Director Keith Fitz-Gerald, a professional trader, is expecting a highly volatile year for oil.

"My personal forecast for 2008 remains unchanged: I believe oil will settle in the mid-$70s, with geopolitically induced spikes sending prices up as high as $187," Fitz-Gerald said this week. "After next year, however, market pressures will send oil prices to the $100 to $125 a barrel level. That price level will be the equivalent of what crude oil is at $30 today."

High oil prices will have one very clear impact, Fitz-Gerald says: So-called "alternative" energy investments will no longer be that.

"The alternative energy projects of yesterday will be the mainstream projects of today," Fitz-Gerald says. "We'll be looking for profit opportunities there."

Regardless of whether oil's current price fluctuations are just part of the harmless ebb-and-flow of a volatile market - or actually a dangerous summit that has lured many to its perilous ledge - there are still plenty of ways to profit.

Drilling For Profit in an Uncertain Market

As Fitz-Gerald noted, with oil prices soaring, oil companies have begun to exploit resources previously considered too expensive - or too dangerous - to tap.

When oil was trading in the range of $20 to $30 a barrel - creating meager profit opportunities for so-called "Big Oil" - companies refused to finance any project that couldn't generate crude for $10-$15 a barrel. Needless to say, rising oil prices have changed that corporate outlook. At $100 a barrel, companies are looking at an array of exploration opportunities.

"The cheap-oil environment of the mid-1980s through the 1990s failed to encourage exploration and production investment," Stephen Schork, editor of The Schork Report, a widely read energy newsletter, told BusinessWeek. "As oil prices rise, we're starting to wake up from that and see a real push for other sources of crude."

In total, producers will spend a record $369 billion on energy projects next year, 11% more than in 2007, a Dec. 7 report from Lehman Brothers Holdings Inc. (LEH) said.

Over the past four years, Exxon Mobil Corp. (XOM) has invested more than $60 billion in exploration and development. Between now and 2010, the world's largest oil company plans to have 20 new oil and gas projects pumping.  

The Chinese government, desperate to lock down supplies of crucial natural resources such as metal ores and crude oil, has sealed deals with Sudan, Chad and the Congo. African Business reports that trade between Africa and China has advanced at a rate of 40% a year since 2001. Last year, bilateral trade between the two was $50 billion.

Already, 14% of China's oil imports come from Angola. About 60% of Sudan's oil goes to China.

China Petroleum & Chemical Corp. (SNP), and PetroChina Company Ltd. (PTR) are two of the biggest Chinese oil companies, and if their recent investments in such political hot spots as Africa and Iran are any indication, China is more than willing to ignore controversy and seek out non-traditional oil suppliers in order to lock down supplies of key raw materials.

Other nations will look to the world's oceans to quench their thirst for crude. Brazil's state-owned oil major, Petroleo Brasileiro SA (PBR), announced last month that the Tupi oil field in the Atlantic Ocean could yield as much as 8 billion barrels of crude. That would make it the second-largest discovery in 20 years. So far, the company has spent five years drilling more than 10,000 feet underwater. Even so, the field is still a decade away from pumping its first barrel.

In spite of such setbacks, investments in deep-sea drilling won't subside.

"With this Tupi discovery, there's going to be a lot of money just poured into this whole thing," Brian Gambill, of Manning & Napier Advisors Inc., told Bloomberg News. "It really sets off a boom."

In a statement that's bound to generate some disagreement, James Wicklund, of Carlson Capital LLC, told Bloombergthat even if oil prices do recede, suppliers of oil equipment and services won't be all that affected.

Exploration companies are "going to continue to buy and install deepwater, sub-sea production systems, whether oil is at $50 or $98," he said.

Cameron International Corp. (CAM) and Baker Hughes Inc. (BHI) are just two companies that are already profiting from the new surge in global oil exploration. They make the valves, pumps, and fluids necessary in extracting crude from deep waters off the coast of Brazil, and in the Arctic. According to Sanford C. Bernstein & Co. LLC, services and equipment companies will generate investment returns of 22% over the next year - double the stock-price returns of the conventional, vertically integrated oil companies.

Cato Brahde, a portfolio manager at Tufton Oceanic Ltd., told Bloomberg that equipment manufacturers are "a better place to be than the integrated oil companies because they're still a growth industry." Those companies, he said, are in a "long-term sweet spot."

However, Hicks, the Global Resources co-manager, still favors the shares of the big oil companies.

"We like Marathon Oil Corp. (MRO) because of its combination of low valuation, strong refining business, and steady upstream production growth," Hicks told MarketWatch.

Fitz-Gerald, the Money Morning Investment Director, thinks there's plenty of energy left for oil-sector investors to profit from.

Fitz-Gerald favors StatoilHydro ASA (STO). StatOil is an integrated oil and gas company that focuses on the exploration, development and production of oil and natural gas from the Norwegian Continental Shelf. It has business operations in 34 countries and proven reserves of 1.675 billion barrels.

The Next Installment of Money Morning's Outlook 2008 Series: China.

News and Related Story Links:

  • Portfolio.com:
    The Coming Oil Crash.