Enjoy Cheap Oil While It Lasts

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We've found out this week just how fast the market can turn bullish on oil. The mere thought that Europe wasn't going to collapse has sent oil from $77.50 per barrel to nearly $85 per barrel in two days.

As the market tanked over the last two months, the one reprieve has been the falling price of oil and lower burden on drivers and businesses. But if Europe is able to figure out its messy financial situation, the U.S. stumbles through the next year or so, and emerging markets such as China and Brazil continue to grow, the relief will be short-lived.

Demand isn't going anywhere
Smaller, more fuel efficient cars and SUVs may be back in style, but that doesn't mean Americans don't still love to drive, and that isn't about to change.

Consumption fell in 2008 and 2009 during the depths of the recession when employees were laid off, product (and therefore trucking) demand fell, and plants were idled, but demand started to return in 2010. Unless the economy takes another complete nosedive, our oil consumption will likely remain flat or rise slightly in coming years.

And that's just a view of the United States. China is probably a bigger driver of oil prices, and with the economy growing around 10%, oil demand is growing rapidly as well. After growing 12% in 2010, crude oil consumption is expected to grow another 6% this year, a big leap for the world's second largest economy.

And Beijing has started restricting the number of private vehicles allowed on its roads, so the demand could be even higher. Similar dynamics are playing out in Brazil and India where growing economies are translating into more consumption of oil. Overall, emerging economies will likely drive oil consumption higher over the next five to 10 years, putting pressure on the price of oil.

Oil prices will drive supply
On the supply side, there are barriers to lower oil prices simply based on economics. Wells are no longer in easy-to-drill places in the middle of Texas, where a well at Spindletop blew oil 100 feet in the air in 1900, or in the Middle East where oil has been abundant.

Instead we're drilling offshore in deeper and deeper water that is more and more expensive. Drillers like DryShips (Nasdaq: DRYS  ) , Seadrill (NYSE: SDRL  ) , and Transocean (NYSE: RIG  ) are building ultra-deepwater rigs as fast as they can to keep up with the demand in the Gulf of Mexico, Brazil, and off the coast of Africa.

Oil shale has also changed the dynamics of oil prices. Kodiak Oil & Gas (NYSE: KOG  ) , Continental Resources (NYSE: CLR  ) , and Range Resources (NYSE: RRC  ) have made tremendous progress bringing down the cost of extracting oil from rocks, but there are still financial limits.

Drilling in deep water and oil shale is only attractive if the price of oil remains relatively high. Andrew Gould, the recently retired CEO of Schlumberger, estimated that the economic cutoff for ultra-deepwater, oil shale, and arctic oil drilling was around $70 per barrel. That's not a large margin of error with oil currently just over $80 per barrel. The higher oil prices go, the more incentive we'll have to keep up with growing demand. But if prices remain where they are or fall further, supply will start to be cut off.

There's also the elephant in the room, OPEC, to consider. OPEC can flip a switch (figuratively) and send worldwide supply lower and prices higher. They're very unlikely to increase supply and send prices lower.

Call me a cynic, but I don't think unrest is over in the Middle East either. Syria is still a mess, Total (NYSE: TOT  ) has just recently started to begin production in Libya, and Iran has its own problems. The Arab Spring is great for the freedom of citizens, but it is almost sure to have a continued negative effect on the price of oil.

Foolish bottom line
The perfect storm of a slow economic recovery, low investor confidence, and new sources of oil production has put downward pressure on oil prices recently. But once confidence returns and the economy begins to grow again, investors will be back on the oil bandwagon.

The last time oil prices fell this dramatically was in 2008, before the economy hit rock bottom. By mid-2009 when unemployment peaked, oil prices were already starting a steady rise.

Rising oil prices aren't all bad, as I pointed out earlier this month. It creates U.S. jobs, reduces our dependence on foreign oil, and makes alternative energy sources more economically viable. In the mean time, enjoy cheap oil prices while you can. This Fool doesn't think the party will last long.

Worried about rising oil prices? Click here to check out our free report called "3 Stocks for $100 Oil" where three of our rising star analysts pick a company that will benefit from rising oil prices.  

Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.

The Motley Fool owns shares of Transocean and Range Resources. Motley Fool newsletter services have recommended buying shares of Range Resources and Total. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 29, 2011, at 11:01 AM, Stoneaa wrote:

    Here is a current sheet of stocks from the major integrated oil and gas industry with best dividend yields. The whole industry has 15 companies of which 8 yielding above 4 percent.

    The average price to earnings ratio (P/E ratio) amounts to 11.3 while the average forward P/E ratio is 8.3. The dividend yield has an average value of 4.5 percent. Price to book ratio is 1.4 and price to sales ratio 1.0. The operating margin amounts to 14.2 percent.

  • Report this Comment On September 29, 2011, at 2:51 PM, dragoncello wrote:

    "There's also the elephant in the room, OPEC, to consider. OPEC can flip a switch (figuratively) and send worldwide supply lower and prices higher. "

    There may be less truth to that than the past, when it was more true that OPEC could control production and thus worldwide prices. There are several reasons for this. 1) Increasingly, world oil production is from non-OPEC countries, thus reducing the cartel's pricing power. 2) OPEC countries heavily subsidize gasoline prices in their own countries, primarily for political purposes (making political stability), thus fueling (ahem) demand in their own countries, thus making less available to export. I read one report estimating that at current rates of both consumption increase and production decrease, that by 2040 Saudi Arabia would become a net importer of oil! That won't happen, but their current subsidies are clearly unsustainable. 3) The Arab world has plenty of investments in Europe and North America, so the strategy would be to squeeze as much from consumers, but never so much to intentionally cause a major recession which would hurt their own investments. (Qatar and Kuwait, for example, earn more from their foreign investments than selling oil and gas.)

    French oil company Total has estimated that 95 million barrels per day is about the worldwide maximum production limit. So yes, if BRIC and OPEC countries continue to consume more oil as their economies grow, then oil prices will go only in one direction. The Nissan Leaf and Chevy Volt look like reasonable vehicle choices for this decade. (I drive a Prius.)

  • Report this Comment On September 29, 2011, at 3:51 PM, Tygered wrote:

    I thought Brazil was big into biofuels. Is that not true?

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