Oil prices hit a wall this spring.
Rattled investors who worried about the direction of the global economy shunned black gold in favor of real gold as a means of preserving capital.
But don't be fooled. The spring retreat simply set the stage for a second-half rally.
After starting the year at about $81 a barrel, prices climbed as high as $86 a barrel before plunging to $64 on May 25.
At work in that period was the same shaky market sentiment that wreaked havoc on global equities. Fears that rising debt levels in Europe and other developed economies would lead to another financial meltdown, and that China and other emerging markets would not be able to sustain their high levels of growth robbed oil prices of the momentum they'd built up last year.
But even as these fears entrench themselves in the minds of investors, demand for oil didn't go anywhere. In fact, it's on the rise.
Projecting A Rise in Oil Prices
The International Energy Agency (IEA) recently raised its 2010 world oil-demand forecast. Worldwide oil use will rise by 1.7 million barrels a day, or 2%, in 2010 to a record 86.4 million barrels, the Paris-based agency said in its monthly market report.
"This revision stems from stronger preliminary readings, notably in North America, where distillate demand appears to have surged in May as the economic recovery gained traction," the IEA said in the report.
U.S. oil inventories dropped by 1.9 billion barrels and 0.7 billion barrels in the weeks ended May 28 and June 4, according to U.S. Energy Information Administration (EIA). And while the EIA last month lowered its demand projections in light of recent economic upheaval, the group still forecasts 2010 demand will increase by 110,000 barrels per day (bpd). Overall oil consumption will surge by 1.57 million bpd to a total of 85.59 million bpd, according to the EIA.
Increased demand at gasoline pumps across the country – while it hasn't yet shown up in the prices, which are at or below levels of a year ago in many parts of the United States – also supports a rebound in oil prices. The EIA reported gasoline inventories fell by 2.6 million barrels in the week ended May 28 as compared to estimates of a 200,000-barrel increase among analysts surveyed by Dow Jones.
Meanwhile, China, the world's second-biggest energy consumer, imported 29% more crude oil in the first five months of this year than it did in 2009. Oil purchases in the January-to-May period climbed to 95.7 million metric tons from a year earlier, according to preliminary data released by the General Administration of Customs in Beijing.
Additionally, fuel stocks at China's major energy companies fell for the third consecutive month in May.
Supply considerations could also play a significant role in driving oil prices higher.
As Money Morning Contributing Editor Martin Hutchinson noted in a recent column, the BP PLC's (NYSE ADR: BP) Gulf oil spill will inevitably result in more stringent drilling regulations that will make it more difficult to bring new oil production on line. That will increase drilling costs, reduce domestic supply and drive oil and gasoline prices higher.
"The business fallout from the oil spill could be widespread," says Hutchinson. "As was true of the Three Mile Island nuclear accident of 1979, the Deepwater Horizon oil spill could end up causing massive damage to companies that were in no way involved with the BP tragedy. Risks of different types of operation will be reassessed, new rules will be enacted, and the energy business will change radically."
The oil spill and any regulations that come as a result don't "necessarily imply a swansong for offshore expansion." The six-month moratorium the Obama administration put on most deep water drilling in the Gulf, if extended, could shave from 100,000 barrels a day to 300,000 barrels a day off the IEA's forecast on Gulf of Mexico output by 2015, the agency said.
Light, sweet crude recently rose 1.5% to $75 a barrel on the New York Mercantile Exchange (NYMEX). That's the highest level since May 12 – a strong indicator that black gold is bouncing back.
In fact, most analysts expect oil prices will remain above $70 a barrel for the remainder of the year – provided there's no financial crisis in Europe.
"If we avoid a meltdown in the European economy, I think we'll see oil in a $70 to $80 range," James Williams, president and energy economist at WTRG Economics told CNN. "But if the euro collapses and Europe goes into a double dip [recession], we could see prices go into a $60 range."
But so long as confidence in a global recovery and petroleum demand continues to increase, oil prices will benefit.
"Today it's a matter of risk versus no risk," said Williams. "If traders keep desiring more risk, you'll keep seeing higher prices."
Investing in Oil
For those with a more speculative bent and the proper trading accounts, oil prices can be played directly in the futures markets, targeting either the crude or gasoline futures contracts.
For long-term investors, however, a more comfortable choice would likely be an investment in an oil price linked exchange-traded fund (ETF). Two in particular are worth a look:
United States Oil Fund LP (NYSE: USO) – This fund invests in various exchange-traded futures contracts for crude oil, heating oil, gasoline and other petroleum products, as well as options and forward contracts, seeking to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light sweet crude oil. The fund's expense ratio of 0.78% is below the average for funds of this type. The fund has $2.15 billion in assets and the 52-week price range has been $30.93 to $42.19.
iPath S&P GSCI Crude Oil Total Return Index ETN (NYSE: OIL) – Actually an ETN (exchange-traded note) rather than an ETF, this fund attempts to track the performance of the Goldman Sachs Crude Oil Return Index, which seeks returns based on the unleveraged investment in WTI crude oil futures traded on the NYMEX. The fund is priced near the bottom of its 52-week range of $20.01-$27.95.
As far as energy companies go, it's probably wise to avoid those directly involved in the Gulf disaster. That would be British Petroleum, or BP (NYSE: BP), of course, plus Transocean Ltd. (NYSE: RIG), owner of the Deepwater Horizon rig; oilfield service provider Halliburton Co. (NYSE: HAL); Cameron International Corp. (NYSE: CAM), responsible for the faulty blowout preventer; and Anadarko Petroleum Corp. (NYSE: APC), part-owner of the well.
Although these companies lost more than $100 billion in market capitalization since the April 28 explosion – and are probably undervalued as a result – their future liabilities with respect to clean-up costs and damages won't be clear for months or even years to come. All will also face future operational restrictions as a result of the ongoing investigations and resulting regulatory changes. (If you insist on taking a contrarian stance among this group, Anadarko probably has the least exposure to the spill and the largest array of alternate resources, making it a decent buy at the recent price of around $39 a share.)
The potential restrictions could also pose a risk, or at least a price restraint, for many of the other major oil companies, such as Exxon-Mobil Corp. (NYSE: XOM) and ConocoPhillips (NYSE: COP).
Similarly, President Obama's new six-month moratorium on additional offshore drilling will weigh heavily on the oil services sector, which has taken a drubbing the past month on weakness in firms like Baker Hughes Inc. (NYSE: BHI) and Schlumberger Ltd. (NYSE: SLB). As evidence of this weakness, the Philadelphia Oil Service Sector index (^OSX) is down 28.3% since its April 23 top.
Given these factors, the best way to play an oil rebound through direct stock investment would be through smaller U.S. companies with little or no offshore activity.
Two possible choices are:
Goodrich Petroleum Corp. (NYSE: GDP) – Based in Houston, Goodrich's activities are focused in east Texas, northwest Louisiana and four other states, where it owns a working interest in 466 active oil and gas wells with proven reserves of nearly 1 million barrels of oil and 415 billion cubic feet of natural gas. Insiders obviously have faith in this company as they've snapped up more than $1 million worth of shares in the last month, taking advantage of the drop in prices since the late April high of $19.19.
Plains Exploration & Production (NYSE: PXP) – Although Plains does have some offshore interests – including a new exploration project off Vietnam – the bulk of its 359 million barrels of oil and oil-equivalent reserves is in California, the Gulf Coast region, the Mid-Continent Region and the Rocky Mountains. The Houston-based company had trailing 12-month earnings of $1.42 a share and the recent price is near the bottom of the 52-week range of $19.28 to $36.60.
Another interesting sector play combines oil with one of the growing alternative-energy sources – wind. Kaydon Corp. (NYSE: KDN) is a world leader in the design and manufacture of custom-engineered, critical-performance products such as bearings, shaft seals, retaining rings, fuel-cleansing systems and metal alloy products. Their services should be in high demand as drillers update equipment and rigs to meet new safety standards. (The age of the Deepwater Horizon rig has already been cited as one of the faults leading to its catastrophic failure.)
Kaydon's systems give you some diversification, too, since they're also used in fields from aerospace and defense to autos and even medical systems. Plus, their bearings and seals are used extensively in windmill energy generators, accounting for 10% of the company's current revenues – with that number expected to triple in the next three years. The company has earnings of $1.48 per share, pays a dividend of 72 cents and the stock is in the lower third of its 52-week range of $29.16 to $45.69.
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