Why Oil Prices Will Rise Again

It was only a few months ago that oil traded at $147 a barrel. Today it trades around $70 a barrel, a fall of more than 50%

Big oil stocks like ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) were flying higher and higher, peaking at around $95 and $100 respectively. Today they trade around $70 and $63.

Smaller companies like ATP Oil & Gas (Nasdaq: ATPG  ) , Mariner Energy (NYSE: ME  ) , and Contango Oil & Gas (AMEX: MCF  ) have been absolutely hammered, plummeting 80%, 70%, and 50% from their respective recent peaks.

How quickly things can change, and how quickly these markets can move.

Back in July, around the time the oil price peaked, common consensus went along the lines of ...

  • The world is running out of oil.
  • World demand for oil is high and only going to get higher still in the years and decades ahead.
  • Most of the world's cheap oil has already been discovered.
  • Oil exploration companies increasingly have to drill for oil in more and more difficult places. This adds to the cost of exploration and in the event of a discovery, the cost of extraction. Either the price of oil stays high and goes even higher, so that it makes these new discoveries economical for the oil companies, or the oil stays in the ground. Given the increasing demand and the world's complete reliance on the naturally depleting natural resource called oil, it has to come out of the ground.
  • Oil was seen as a natural hedge for the falling U.S. dollar.

In July, even though it was already clear the economy was slowing, and therefore oil consumption would slow, no one was really concentrating on that. The oil price speculators and peak oil theorists were having a field day. Analysts were falling over themselves to predict higher and higher oil prices.

As far as I can see, Goldman Sachs (NYSE: GS  ) analyst Arjun Murti won that particular competition back in May, warning people to expect $150 to $200 a barrel oil prices over the next six to 24 months. To be fair, we're only a few months into the prediction, but right now, with oil at around $70 a barrel, $200 looks a long way off.

It was those dastardly hedge funds again
In hindsight, it now seems likely speculators were driving the oil price higher and higher, all the way up to its $147 peak in July. Hedge funds were no doubt in on the act, and when they smell a dollar, they move fast. The upward spiral suddenly becomes self-fulfilling, with people convincing themselves that this time it really is different, and that $100+ oil prices were here to stay.

Fast forward to now, and there's a chance the oil price has moved too far the other way, driven down by hedge funds and just about everyone else selling everything they can, before it's too late. It too is caught up in the global credit crisis.

There's also a chance the oil price is acting in an entirely rational way. For example, the Department of Energy's weekly report showed crude oil supplies rose 5.6 million barrels to 308.2 million barrels last week, and U.S. fuel demand was at its lowest level since June 1999. Crude oil fell below $70 a barrel.

So what's happened today to all those 'peak oil' arguments being made just a few short months ago? Do they suddenly become obsolete, meaningless and another casualty of the global credit crisis?

Oil still makes the world go round
I don't think so. The world's utter dependence on oil remains unchanged. Oil is still a depleting asset. New oil finds of any significance are still extremely rare, and even then, not large enough to move the needle. For example, the biggest oil discovery for the past eight years, the huge "Tupi" oil field offshore of Brazil, is estimated to contain up to 8 billion barrels of oil. Nevertheless, with global oil consumption currently running around 86 million barrels per day, the Tupi field is only sufficient to meet less than 100 days of global demand!

In the face of this forthcoming global recession, the International Energy Agency (IEA) has been dropping its demand forecasts for oil, their most recent report saying they expect oil demand of 87.6 million barrels per day in 2009.

Who knows if they'll be right? I don't. This global financial crisis has wrong-footed just about everyone to date, and the forthcoming global recession may be deeper and longer than even the most pessimistic forecasts. We are in unchartered territory.

Oil is now trading beneath its floor
But what about the oil price? Should it be $50 or $100 or $150 a barrel? In the short-term, as we've recently seen, anything is possible. The oil price, like stock prices, was once being determined by greed, and now is determined partly by fear.

In the longer term however, assuming oil demand grows around 1% per annum, it all depends on the marginal cost of discovering a new barrel of oil. A report by Sanford C. Bernstein said the marginal cost of supply is currently estimated to be about $75-$80 a barrel.

That should set a long-term floor of around that level. With oil at $70 today, we're already beneath that floor, meaning the upside to the oil price should be greater than the downside, in the longer-term.

The oil bulls will win again
The long-term bull case for oil remains intact. But right now, the major oil companies are again priced like boring utility companies. With the oil price falling, they are not growing, and therefore trade on single digit price to earnings ratios (P/E). That's ok. Over time, they should continue to churn out good profits and make decent returns for shareholders.

The real action for oil bulls will come again for the smaller oil producers who are also sitting on highly prospective acreage and/or high levels of reserves. Their share prices have been slaughtered as the oil price fell and every hedge fund and his dog sold out in the great stock market panic of October 2008, but their time will come again.

Of the smaller companies mentioned above, ATP Oil & Gas and Contango Oil & Gas might be worth a closer look. Happy drilling.

What now? The Motley Fool is here to answer your questions about this financial crisis. Send us an email at AsktheFool@fool.com, and check back at Fool.com as we answer your questions and cover the latest on the Panic of 2008.

Fool contributor Bruce Jackson doesn't have a beneficial interest in any of the companies mentioned in this article. The Motley Fool's disclosure policy is a gusher.


Read/Post Comments (6) | Recommend This Article (23)

Comments from our Foolish Readers

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  • Report this Comment On October 17, 2008, at 6:38 PM, majicworm wrote:

    finally gave up on hov and sold at a great loss. with that dough, i bought atpg and it immidiately tumbled. so, if you want to know what i'm buying next, call and do the opposite.

  • Report this Comment On October 17, 2008, at 8:10 PM, Tiingall wrote:

    From my understanding, oil running out is a myth. About eight years ago a friend of mine resigned from a major oil company - to be re-employed three months later by the same company as a contractor on triple the salary - to work on developing technologies to extract what at that time he said was the other 90% of what's there and does not figure in the official reserve statistics. His comment was don't waste your time discussing the topic of oil running out, it's a non-existent issue; "your great-great gandchildren and their great-great grandchildren and their great-great grandchildren don't need to even think about it."

    He also said most big oil companies are looking about 20 years ahead in terms of scheduling development of these new technologies so they are ready to implement in fields where the (presently proven) 10% that's easy to get is projected to run out.

    I've checked with other oil/gas people since then and they all confirm the same - that most big oil companies are investing in the technologies to get at this other 90% in existing fields, rather than spend masses to search for new areas of the 10% that's easy to get. Exploration and establishing infrastructures for a completely new area is far more expensive than developing the new technologies to use in existing areas.

    As recently as February this year I asked a group of engineers and geologists working with a big oil company - and their contractors - the same questions and they confirmed it yet again.

    I live in SE Asia, and whenever a government controlled oil company is told to find more oil reserves - usually because the government wants more income for other projects - they go and do it. My observation is that unless oil and gas companies need to find more oil/gas - eg: to have something to sell - they don't bother. Exploration is very expensive and reduces current profits, so why do it if it's not necessary.

    I recall in the 70's oil crisis there was talk about oil running out in 20 years; but it hasn't. The same has been said numerous times since; but it hasn't. Twenty years seems to be the magic period the industry works with as lead time to find and bring new fields - or new technologies - into operation. The official statistics will probably always say 20 years of reserves. It no doubt helps keep oil prices - and anxiety - up.

  • Report this Comment On October 18, 2008, at 3:25 AM, shizuokablue wrote:

    Tingall, when discussing Peak Oil with someone, there is inevitably a "tell" in which it is obvious that he or she "gets it". And, unfortunately, you don't get it.

    In short, oil is an infinite resource and, at some time, the production of crude oil must peak. No matter how much oil there is in the ground, no matter how much there is locked in tar sands and oil shale, production will peak. That peaking point is "peak oil". It is not a theory--or if you view gravity as a theory, or the digestive process as a theory, then perhaps it is one--and it only the size of the flow--not the resources in place matter. If it flows at 87 million bbl a day and then shrinks to a level below that, without being able to return to that level...then we have reached peak oil. There could be another 100 billion bbl somewhere on earth, but it matters not a whit if we cannot find them and/or process them in a timely manner.

    As for oil actually running out, well of course it will never actually run out. By the time oil gets to a certain level of production we will have either moved on to something else and are using very little oil or we will not have found a way to make a transition to other sources of energy for our transportation and food production and we will have collapsed in someway and to some lesser level. Oil will always be in the ground regardless of our technology and extraction ability.

    It is really rather irrelevent.

    flow rather than reserves,

    a liquid fuel shortage,

    fewer and fewer significant finds,

    emerging economies based around consumption, the internal combustion engine, fossil fuels and throw-away products, a lack of renewable fuels as replacements. These factors, combined with profound lack of knowledge of the problem on the part of the public and an equal lack of leadership from politicans, all add up to the most serious crisis our world has ever faced. Until people like you stop living in denial, we will only make serious attempts to mitigate this crisis once we are in the middle of it. By then, it will likely be too late.

    Stuck in Shizuoka

  • Report this Comment On October 18, 2008, at 6:30 AM, shanus wrote:

    Tingall.. you are correct when you say there is plenty of oil left, it is just the cost of extraction will rise, both with inflation and the fact that most of it resides 2000m beneath the floor of the ocean at ocean depths of 3000-6000m.

    It is also likely that land based deposits 5km below the surface, but the cost of drilling at the moment is too prohibitive

    Extraction methods from oil sands, and high porosity shale/rock will also get better, but that too will come at an increased cost.

    I see oil getting to $300 per barrel in the next 5 years, but when it gets there people will start to question.. why are we burning this stuff? can we do better? And only then will we see technological adaptations away from the carbon economy.

    I was at a conference years ago for hydrogen fuel cells... funny enough sponsored by major oil companies. I could not see the connection, as I thought fuel cell technology would be a threat to the oil industry. This was until I found out the best rate of hydrogen extraction is from hydrocarbons... the rate of hydrogen extraction from water is too low to make goof fuel cells. so we will still use oil.. but we will just be less likely to burn it in the future.

  • Report this Comment On October 18, 2008, at 7:16 AM, saumy wrote:

    The current oil trend shows that the oil prices will take almost a year and a half to reach the target of 150 dollars a barrel . will the sudden down fall in oil prices affect the rates of electricity and other basic amenities all round the world . please give light on this also.

    because this is a very important factor

  • Report this Comment On October 18, 2008, at 12:55 PM, JeffreyMorton wrote:

    As I see it, peak oil = demand for oil.

    As the price of oil encourages cheaper alternatives to be developed, and as the world transitions to these cheaper alternatives, demand for oil will decline. This will define the peak in oil production... no energy company would produce more than demanded.

    Stated differently, the price of oil is a double-edged sword. Price must rise to pay for higher costs of extraction. When the cost of extraction rises above the level of any viable alternative source of energy, we will reach 'peak' oil.

    Thus, from the perspectives of the double-edged sword analogy, Bruce Jackson's article and all comments made to this point are reasonable assessments from the perspective of one edge of the sword or the other.

    Given the inherent ambiguity this causes, discussions invovling the use of 'peak oil' will continue to spark lively debates on the issue.

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