Cashing in on Commodities: What's Driving the Oil Bull, How Much Further It Will Go, and How Investors Can Profit

Editor's Note: This is the second installment of a new Money Morning series highlighting investment opportunities created by the global bull market in commodities.

By Jason Simpkins
Associate Editor

Exactly 12 months ago, West Texas Intermediate crude oil was trading at just under $63 a barrel.

Yesterday (Thursday) futures prices for that benchmark grade of crude oil hit the latest in a succession of record highs, punching through the $135-a-barrel mark on the New York Mercantile Exchange, before sliding back.

In other words, in only a single year, crude-oil prices have more than doubled, soaring 115% - and setting 27 separate new records along the way. And while a short-term correction may be in the offing - especially with fears of a U.S. recession ebbing - the reality is that oil prices are nowhere near the end of their run, meaning the United States is really an economic system that's at the crossroads.

"The market is less worried about the economy and subprime problems," Tim Speiss, head of the wealth-management arm of Eisner LLP, told "But that's near-sighted. If oil stays above $130 a barrel, that's a very significant event and a lot of the sectors of the economy would have to be re-engineered."

Commodities of all types are at or near all-time record highs. And the impact - on a global basis - has been as startling as it is far-reaching, affecting consumers at all income levels and in every market across the world.

Even so, here in the U.S. market, it's the price of oil - and of gasoline - that continues to dominate the headlines. Like a junk-food junkie who's constantly searching for a sugar fix, the U.S. economy is addicted to foreign oil. And because it's not a habit we're going to kick anytime soon, U.S. consumers will be forced to live with the heinous consequences.

Given that harsh reality, shrewd investors will look for ways to offset that largely unavoidable pain with some well-placed profit plays. Before we can do that, however, a look at the basics is necessary.

Oil Prices 101

Since 2005, global oil production has remained stagnant, but demand has increased exponentially. Even if American consumers are unwilling to pay $4 a gallon for gasoline, and U.S. demand plummets, global demand will continue to rise.

Eduardo Lopez, an analyst with the International Energy Agency, told The Independent that America's role as the global oil-price arbiter - the United States consumes one out of every four barrels of oil used worldwide - is dwindling.

"Demand is coming from emerging markets. As long as the [United States] doesn't collapse, it doesn't really matter if the mature economies are slowing," Lopez said.

While the IEA expects demand in industrialized countries to decline by 0.7% (about 300,000 barrels of oil per day) this year, the Paris-based group says oil consumption in the rest of the world will grow by 3.7% (1.4 million barrels a day).

The net increase is due chiefly to the rapid growth in China and India.

Fueling the Fast-Growing Economies of China and India

According to the China Petroleum and Chemical Industry Association (CPCIA), China's apparent consumption of petroleum byproducts such as gasoline, diesel and kerosene rose 16.5% year-over-year in the first-quarter. Crude oil consumption jumped 8%.

China's net imports totaled 44.95 million metric tons in the first quarter, up 15%, and net imports of oil products rose by 32% from a year ago, according to the Asian nation's General Administration of Customs.

And now that the most powerful earthquake in 58 years has ravaged the country's infrastructure - smashing roads, leveling refineries, and shutting down hydroelectric plants - China has been forced to supercharge its imports of diesel and jet fuel just to supply power generators and airports to help it accelerate the desperate rebuilding process.

Ultimately, the IEA sees China's oil demand more than doubling to 16.5 million barrels a day by 2030.

But that's nothing compared to other emerging hot spots, where demand is expected to rocket sevenfold during that same stretch.

Just look at India, another big country with a pedal-to-the-metal growth rate. That country is expected to overtake the United States, Japan, and China as the world's leading net importer of oil by 2025.

In 1970-71, India was importing 11.66 metric tons of crude oil. By 2005-06, however, the imports had increased to 99.40 metric tons, the Economic Times reported. Since 1997-98, alone, petroleum imports have almost tripled. Nearly 76% of India's domestic oil needs are met via imports.

And it's really no wonder: India's demand for oil is expected to grow by 8%-10% this year alone.

Together, China and India will account for 45% of the increase in global primary energy demand through 2030. The two countries' net oil imports are expected to jump from 5.4 million barrels in 2006 to 20 million barrels a day in 2030, which could create a "supply crunch" as early as 2015 according to the IEA.

The Pending 'Supply Crunch'

There's no avoiding the fact that the world will one day run out of oil. In fact, the biggest field in the world, Saudi Arabia's Ghawar field, is only a shadow of its former self. It was originally discovered in 1948. And since the 1970s, the oil field has required large-scale injections of seawater - a technique used to artificially pressurize an oil reserve that's on the decline.

Ghawar isn't the only spot where this seawater saga is playing out. As the biggest, most-accessible, and most-cost-efficient wells on the planet dry up, oil producers are struggling to replace them.

To do so, they've been forced to experiment with challenging and costly deep-sea drilling expeditions. Such heavy-hitters as Exxon Mobil Corp. (XOM), BP PLC (BP), Total SA (TOT), Chevron Corp. (CVX), ConocoPhilips (COP), and Royal Dutch Shell PLC (RDS.A, RDS.B), will spend a record $98.7 billion this year on exploration and production, according to Lehman Bros. Holdings Inc. (LEH).

Exploration costs have more than quadrupled since 2000, as oil producers have been forced to take on more complex projects and the costs of both labor and materials have skyrocketed. In just the past eight years alone, the cost of finding and developing a barrel of crude oil soared from $4 to $18, Andrew Latham, vice president of exploration services at consulting firm Wood Mackenzie Ltd., told Bloomberg News.

The Kashagan field in Kazakhstan, a group of international oil majors led by Italy's Eni SPA (ADR: E), is eight years behind schedule and approximately $80 billion over budget. The fact that the deposit is located in the icy depths of the Caspian Sea has forced contractors to build artificial islands to operate from. Kashagan's crude also has high hydrogen-sulfide content, which makes it potentially deadly for workers on site, and which at the same time also raises unusually difficult environmental-engineering challenges.

According to government officials, the overall cost of the project has ballooned from $57 billion to $136 billion.

Brazil's Carioca field is another reserve with tremendous potential, as it may hold 33 billion barrels of oil and natural gas. Unfortunately, the field is 170 miles offshore, more than 6,000 feet under the surface of the water, and trapped beneath a shelf of salt 500 miles long and 125 miles wide.

Technologically challenging, physically intensive and costly projects like these are the future of the oil industry. Drillers could access only 7% of known world reserves in 2005, down from 85% in 1970, according to the National Petroleum Council.

"The international oil companies cannot dictate the tempo any more," Fadel Gheit, an analyst at Oppenheimer & Co. (OPY), told Bloomberg. They can try projects that didn't work two years ago, but it's not a question of money. They don't have access to the resources."

Oil companies also are beginning to search for oil in unstable regions of the world - geopolitical hot spots that may previously have been considered political liabilities. Countries such as Nigeria, for instance, lack the infrastructure and political support to produce oil efficiently.

The Movement for the Emancipation of the Niger Delta (MEND) has made life particularly difficult for oil majors in Nigeria by bombing pipelines and kidnapping workers.

"Our candid advice to the oil majors is that they should not waste their time repairing any lines as we will continue to sabotage them," the rebel group said in a statement recently.

In 2007 alone, more than 200 foreign workers were taken hostage, many of whom were released after a ransom was paid. It's estimated that bombings, kidnappings, and other terrorist incidents have reduced Nigeria's total oil production by 25% over the past two years.

In its Monthly Oil Market Report for May, the Organization of Petroleum Exporting Countries (OPEC) cut its estimate for supply from such non-member countries as Nigeria, but refused to boost its own output. Instead, OPEC insists enough oil is on the market and that demand will fade in light of a U.S. economic slowdown.

But many economists now say that the prospects for an actual U.S. recession have all but disappeared.

Fundamentals vs. Speculation

OPEC's unwillingness to pump more oil and relieve mounting supply pressures has helped propel the price of oil to its recent record levels.

"If traders feel OPEC is signaling it is comfortable with $100 [per barrel oil], then fundamentals are appraised from that new base. OPEC's silence as we neared $120 raised perceptions of an even higher floor," the IEA said. 

Indeed, the IEA's Lopez noted that "OPEC loves to argue that it's all speculation, but we shouldn't overplay that. It's becoming a lame excuse ... speculation is a factor, but it accompanies a trend, it's not setting the trend. This is down to fundamentals."

Lopez's point is well taken, but there is a manic element to what's happening on the NYMEX: Investment banks up and down Wall Street, and day-traders across the country have pile-driven their way into the piping-hot oil market for quick gains, which is fueling the speculative frenzy and helping push oil and gasoline prices even higher.

In fact, now many investors who were initially betting that oil prices would drop are shifting gears and betting oil will move even higher to cover their losses.

The number of outstanding futures contracts - known as "open interest''- fell 8.1% in one week to 1.36 million contracts, even as prices rose 2.6%, according to a recent report by Bloomberg News. Falling open interest and rising prices are signs that traders are buying to exit short positions, the analysis article noted.

The number of short positions held by traders hit a record high of 123,194 in the week ended May 6 - 47% more than the number of long positions, which pay off if the price moves higher.

A Possible Bubble

The climbing level of investor interest in the oil market has many analysts anticipating a correction sometime in the near future. 

"We were only trading at about $86 about three months ago and not a whole lot has changed to move us to where we are now," Addison Armstrong, director of market research for traditional energy TFS Energy LLC in Stamford, Conn., told MSNBC. "There's no doubt in my mind - and most other people I speak to - we are in a bubble. And it's going to deflate at some point."

The U.S. dollar gave oil a boost by falling to historic lows throughout the first quarter of the year, but has begun to show some signs of life as the U.S. Federal Reserve has signaled it will cease cutting the benchmark Federal Funds rate.

A sluggish economy and record high gasoline prices are also likely to blunt demand moving forward.

Besides, oil is a historically volatile commodity, anyway. In 1986, oil prices started the year at $26 a barrel - but by March, had fallen to $10.25 a barrel. In 1997, prices almost climbed to $23 a barrel - before falling below $11 a little more than a year later.

While some analysts are waving caution flags - and perhaps rightly so - others remain bullish on oil's long-term outlook.

"When I hear bubble, I'm thinking of a technology bubble where we spike up and we just never come back to it again," Chris Jarvis, an energy analyst at Caprock Risk Management LLC, told MSNBC. "I don't think that's the case. I think if anything you're talking about more of a short-term pullback. What is short term? I don't know, nine months to a year. But the trend higher is still intact. I would definitely not call it a bubble."

How High Will It Go?

Swiss banking giant UBS AG (UBS) expects oil will average $115 a barrel this year, before reaching an average of $156 a barrel by 2012.

Goldman Sachs Group Inc. (GS), which just a few months ago predicted oil would climb to $107, recently increased its forecast to $141 a barrel by the end of the year.

In fact, both Goldman Sachs and JP Morgan Chase & Co. (JPM) recently put forth scenarios that have oil soaring over $200 a barrel within the next two years.

Of course, Money Morning Investment Director Keith Fitz-Gerald - one of the first investment gurus to predict triple-digit oil prices - has gone a step further, suggesting prices will spike as high as $225 a barrel

"The math is really simple here," Fitz-Gerald said in a recent e-mail interview from China, where he was heading an investment-research tour at the time. "We are burning through supplies at a rate that's four times to five times faster than we're discovering new reserves. Throw in a few [surprises] ... perhaps a terrorist event ...and add in the accelerating use of oil and gasoline in Third World countries, and we have the recipe for far higher prices. That's already in the oven."

In addition to the proprietary strategy he uses to project market prices, Fitz-Gerald said he relied on some of the observations he'd been making as part of the investor trip he was leading through China and Hong Kong. He also made a stopover in Japan.

In China, it only takes a stroll down the street to see that the demand for oil and gasoline is going to increase far faster than most U.S.-based analysts would ever believe - or understand.
"Nowhere is that more evident than China where I'm traveling now," Fitz-Gerald said in that interview. "Beijing alone is adding 1,500 cars a day. Across China, the number is obviously higher. [The] same [is true] in India, but [to a lesser degree]. Then there's the other side ... evidence suggests that OPEC reserve figures may be artificially high. Imagine what's going to happen when people figure out that there really isn't as much oil as everybody thinks. $225.21 is not out of the question ... after we get to $187," which is what his initial target price had been.

Famed investor and best-selling author Jim Rogers shares Fitz-Gerald's belief that the OPEC cartel may be guilty of some slight of hand in reporting its reserves.

"Saudi Arabia has announced for 20 years in a row that they have 260 billion barrels of oil in reserve," Rogers recently told Money Morning during an exclusive interview in Singapore.  "It's astonishing.  The figure never goes up and it never goes down.  They have produced dozens of millions - billions - of dollars of oil in that period of time.

"If you go to Saudi Arabia, you have to wonder: 'How could this be?  How could it be that every year for 20 years in a row, you always have 260 billion barrels of oil in reserve?'  The Saudis say: 'You either believe us or you don't.' And that's the end of the conversation."

While a short-term correction in the price of oil may, or may not, be in the cards, there is no dispute about oil's long-term profit potential. Supplies will continue to tighten, demand will continue to increase, and political clashes will continue to spark price spikes even steeper and wilder than the one we're experiencing right now.

A Trio of Petro-Profit Plays

Money Morning's Fitz-Gerald has developed a three-pronged energy-investment strategy for investors who wish to capitalize on his forecast for crude oil prices:

Go Deep: As Fitz-Gerald noted, with oil prices soaring, oil companies have begun to exploit resources previously considered too expensive - or too dangerous - to tap into. 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 a cost of $10-$15 a barrel. Needless to say, rising oil prices have changed that corporate outlook. At $130 a barrel, companies are looking at an array of exploration opportunities.

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

Fitz-Gerald favors StatoilHydro ASA (ADR: 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, proven reserves of 1.675 billion barrels and is expanding aggressively to diversify internationally.

In March, the company announced plans to spend as much as $2.1 billion on operations in Brazil and the Gulf of Mexico. It bought the 50% stake it didn't already own in Peregrino, a heavy oil field in Brazil, and 25% of the deep water Kaskida discovery in the Gulf of Mexico, from the Texas-based Anadarko Petroleum Corp. (APC).

Target China: According to Fitz-Gerald, every investor must have a China strategy. And that also holds true for the energy sector. CNOOC Ltd. (CEO), China's offshore oil and natural gas explorer, is a prime candidate to fulfill both requirements. At $198.19, the shares are closer to their 52-week high ($218.20) than they are to their 12-month trading low ($90.58), and are on the pricey side, Fitz-Gerald says. But as a long-term play on both China and on oil prices, investors with the patience to let such a strategy play out may find this a profitable pick, he said.

Goldman Sachs on Friday upgraded the shares from a "Neutral" to a "Buy," citing a profit forecast for this year and next that's much more aggressive than the consensus Wall Street estimate. Given the weak dollar, CNOOC could also be on the prowl for acquisitions, which would further boost its earnings potential.
Explore Your Alternatives: As Fitz-Gerald likes to say, "alternative energy is an alternative no longer." Just as the massive upward move in energy prices is jump-starting deepwater drilling, it is also supercharging innovation, starting with research into alternative fuels for automobiles and then moving into alternative sources of energy for the production of electricity for towns, cities and countries.

Ultimately, the United States government is going to have to get serious about promoting alternative-energy research - much more so than it is now, Fitz-Gerald says.
That hasn't happened, yet. But don't let that deter you: Even now, investment opportunities abound.

And yet, investing neophytes need to understand that this arena can be as tricky as investing in raw Internet startups - you never know which firms will thrive and which will founder. For that reason, it's a sound strategy to turn to a fund manager with alternative-energy savvy of its own. Indeed, there are a number of exchange-traded funds (ETFs) that focus on "clean" technology. But we like Fitz-Gerald's choice: The PowerShares WilderHill Clean Energy Fund (PBW).

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