Is It Time to Buy Oil?

Even Warren Buffett has been bamboozled by oil.

He admitted it in his latest annual report to the shareholders of Berkshire Hathaway (NYSE: BRK-A  ) -- the holding company he runs. In his own words: "I bought a large amount of ConocoPhillips (NYSE: COP  ) stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year."

Specifically, he made the bulk of his purchases during the six months ending Sept. 30, 2008 -- you know, the same time in which oil prices peaked near $150 a barrel.

The price of oil is now around $50 a barrel, and ConocoPhillips' stock price has tanked in lockstep with the oil freefall. Buffett clearly bought oil too early. But is it still too early for us to buy up oil stocks now?

Now may be the time

Those bullish on oil point to the inevitability of "peak oil," arguing that the time will come when we hit the peak of global oil production. From that point on, we'll be able to pump less and less oil out of the ground. In economic terms, we'll face decreasing supply.

Meanwhile, bulls argue that demand will increase greatly, as China and other emerging markets fuel their economic growth with oil. On average, each person in the U.S. consumes about 25 barrels of oil a year; each person in China consumes just more than two. That's a lot of possible future demand.

And all of us amateur economists know what happens when you restrict supply while simultaneously increasing demand: prices rise.

But then again ...

Um, weren't these the same arguments made when oil was at $147 a barrel? Yup. At that price, all these favorable supply and demand assumptions were baked in, and then some. The subsequent price fall highlights that we'll only make great returns if we buy at low prices.

With oil prices at a third of their summer highs, oil plays are certainly tempting now. Getting in at steep discounts to the prices Buffett paid is a wonderful thing. However, when we look back in time, we see that current oil prices are four times the lows of the late 1990s.

In other words, looking at price movements by themselves just isn't that helpful. We need to estimate oil's intrinsic value.

How do we do that?
Beyond bubbles and busts, oil should sell at its marginal cost of production, plus some profit. Unfortunately, that's not easy to calculate with much precision. Some oil sources are really easy to find and extract (traditional onshore) while others are especially onerous (especially oil sands and deepwater).

Then there's the Achilles' heel of oil: alternative fuels and the vehicles they power. Just as the solar cells made by First Solar (Nasdaq: FSLR  ) and Suntech Power (NYSE: STP  ) become more attractive when fossil fuel prices rise, high oil prices increase demand for alternatives like hybrids and hydrogen-cell cars. The development of these sorts of substitutes for the fuels brought to you by Big Oil players such as ConocoPhillips, Chevron (NYSE: CVX  ) , and ExxonMobil (NYSE: XOM  ) can act as a price ceiling for oil.

Thus, I view the promise of alternative energy as a long-term capping mechanism on runaway oil prices.

OK, so is oil a buy?
The question boils down once again to supply and demand. If peak oil is a ways off, demand slackens, and alternative energy options evolve quickly, a high oil price isn't justified. But if our oil supplies become constrained, the world greatly increases its energy lust, and alternative energy players hit snags, it's off to the races.  

Here's an additional data point to keep in mind. After admitting his timing error on ConocoPhillips, Buffett went on to say, "I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price." Before we dismiss his opinion because of his poor judgment on ConocoPhillips, let's remember his investment in PetroChina (NYSE: PTR  ) .

In 2007, he sold shares that he bought just five years prior, for more than a 700% gain! Since then, PetroChina's stock price has plummeted nearly in half of where it was when he sold.

Buffett's optimism is certainly encouraging. But regardless of the supply and demand outlook, I think some exposure to oil companies makes sense as an insurance policy. When the price of oil rises, most companies suffer from higher input costs and slackening demand. An investor's best defense lies in owning stock in the oil companies that stand to benefit.

In the near term, our dependence on oil isn't going anywhere, and the general trend of rising marginal costs of production provides a cushion for oil prices. The scarier risk is not exposure to oil stocks if oil prices fall, but a lack of exposure to oil stocks, should prices skyrocket again.

Our Global Gains newsletter service recommends a number of oil plays, including one from China. (No, it's not PetroChina.) If you're looking for some oil ideas, or just interested in learning about some intriguing international investments, I invite you to enjoy a 30-day free trial by clicking here. You can read up on all of the team's recommendations with no obligation to subscribe.

Anand Chokkavelu owns shares of Berkshire Hathaway. Suntech Power is a Motley Fool Rule Breakers recommendation. Berkshire Hathaway is a Motley Fool Stock Advisor and Motley Fool Inside Value selection. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.


Read/Post Comments (19) | Recommend This Article (188)

Comments from our Foolish Readers

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  • Report this Comment On April 03, 2009, at 5:52 PM, edlwhite wrote:

    Long term I am still bullish on oil. That said, oil and stocks associated with oil such as oil services have had a big run up in the current rally. They may be due for retracement. Recently the EIA decreased its average price estimate for oil based on a forecast of further decreased demand this year. Apparently EIA also says that IEA is going to reduce their world demand estimate for oil for this year next Friday (April 10). The current EIA 2009 average oil price estimate is in the $42-$43 range. The current price of oil is about $52.50. The COP CEO has estimated (when the price of oil was lower) that the price of oil would be in the $50-$60 range this summer. If all of this is anywhere close to correct, it all likely means that oil is heading downward in the near term. This would fit with a near term market retracement. Then oil would be able to rise into the $50-$60 range again for the summer driving season / hurricane season.

    Even given all of the positive government actions recently, we are still in a very negative economic condition. The mark to market changes may reduce the depth of the recession, but they will likely broaden the bottom at the same time. The write offs will be put off for longer, but many will still occur. We are still heading toward 10+% unemployment. The housing prices have still lost 19% year over year. This likely means still huge numbers of foreclosures as more people are underwater and unemployed. The commercial real estate market is supposed to implode this year. The credit card business is facing mounting default rates as more people are unemployed. More people will be pinching pennies in the near future. More people will be driving less. The near term demand for oil should be low throughout 2009 and into 2010. If the peak unemployment occurs in the fall, demand will continue going down until then. This should not cause oil prices to rise.

    On the flip side, I am bullish on oil long term. China, India, Brazil, Russia, etc. will all use more oil in the future. This should provide a huge upside to demand even considering the contribution of solar energy. I don't want to play this yet though. I think the time to start think about playing oil long term is when the unemployment rate decreases for two consecutive months in the US. That will likely mark the bottom of the recession (or be slightly past the bottom). We are an oil glutton. When we start buying more oil again, that will likely be the force that drives the oil market higher longer term. Thus far the overriding demand trend for oil in the US is down.

    I may play the market rallies and falls as they emerge.

  • Report this Comment On April 03, 2009, at 5:59 PM, eaglesjazz wrote:

    I am a new subscriber yet I don't seem to be getting any of your reports nor many of your specific recommendations in your emails. Am I not registered?

  • Report this Comment On April 03, 2009, at 11:26 PM, exseries7 wrote:

    As a resident of China for the past four years, I think there is some faulty logic in the comparison of American vs. Chinese per capita oil consumption. The Chinese are extremely frugal in their personal use of energy and many do not heat nor cool their homes even in the most extreme weather conditions.

    Certainly they will change some along with rising affluence, but not to the same extent as individual Americans or other westerners. Chinese corporate demand will probably account for the majority of increases rather than personal consumption.

    As for me, I am investing in natural gas producers and infrastructure companies because I'm betting that gas will replace coal in many U.S. generating plants because of green concerns.

  • Report this Comment On April 04, 2009, at 3:01 AM, AirForceFool wrote:

    laogao...

    So you have no posts on the boards, no Caps picks, and we're supposed to take your rants to heart? Don't get me wrong, no one like to lose money, and this market has been terrible.... trust me, I went heavy on FRPT ( an RB pick)... but if you came simply to pay for advise, and hope it works out, you're missing the boat... cut your losses and move on... personally I love beating up the Fool... but post facts... which options are you buying and selling... what's the volatility, and what's your thesis for the purchase or sale... or are you blindly following another news service? If so, then no need to post... I can jack my portfolio up all by myself, and then if I do, I'll at least know who to blame... Chris

  • Report this Comment On April 04, 2009, at 4:45 AM, counos wrote:

    This article just rants on and on, without any Caps picks, and no advice one way or another. Get your act together!

  • Report this Comment On April 04, 2009, at 8:48 AM, olee100 wrote:

    Amen to most of the above bloggers. The author is not even discussing the right subject. What powers the solar factories? Clue - It's not just solar. What fossil fuel is used in the production of hydrogen? Not solar, either. I have no idea whether of not it's time to buy COP and XOM, but a discussion about integrating the entire energy industry would be helpful to me.

  • Report this Comment On April 04, 2009, at 9:57 AM, max12345 wrote:

    "OK, so is oil a buy?

    The question boils down once again to supply and demand. If peak oil is a ways off, demand slackens, and alternative energy options evolve quickly, a high oil price isn't justified. But if our oil supplies become constrained, the world greatly increases its energy lust, and alternative energy players hit snags, it's off to the races"

    Yes, it does boil down to supply and demand. Moreover, as a hedge against possible future inflation oil is an excellent buy. (if I look out my window I see plenty of people zipping around in their cars and very few wearing gold bracelets) (not to mention that airplanes that will fly on solar power or wind energy or nuclear plants are a bit of a way off)

    Let's now look at the arguments con and pro one by one:

    1) "If peak oil is a way off" ...is not a very likely proposition since it is more likely to already be behind us. (though no one can really define "peak" with any precision)

    2) "if demand slackens"....this is likely to occur if China and India decide to stop growing and simultaneously the U.S. and Europe decide to consume a lot less oil. Likelihood: Zero

    3) "if alternative energy options evolve quickly"....the technology has already been there for quite some time and it hasn't happened. (but of course anything is possible)

    4) "a high oil price isn't justified". A high oil price doesn't have to be justified to make money on oil stocks. Just one that is one third of the way from where it is right now (about 45) to its old 2008 highs of 145. That would be enough to send some of the smaller oil producers skyrocketing. (and that is also one of the big differences between buying at its historic high hoping it might go higher and buying now way below that historic high)....(once someone has scaled Everest once, he or she might be more likely to want to try it twice)

    Versus:

    "But if our oil supplies become constrained, the world greatly increases its energy lust, and alternative energy players hit snags, it's off to the races"

    1) "IF" our oil supplies become constrained? Aren't they constrained enough as it is? Or do Hugo Chavez and Vladimir Putin and the King of Saudi Arabia first have to own them ALL? (now that at least Saddam is gone)

    2) And isn't there a big likelihood that the world is going to continue to increase its "lust" for just about everything, also including energy? (it's been on an "increasing its lust" track for at least the past 20,000 years)

    3) And "if alternative energy players hit snags"....even if they don't hit any snags at all and grow by leaps and bounds they will not be able to replace oil. (either quantitatively or qualitatively for at least 30 years)

    In other words there is a 90% chance of the former against a 10% chance of the latter. Those seem like pretty good odds to me. So I am off to the races.

  • Report this Comment On April 04, 2009, at 11:18 AM, intxicated wrote:

    "Beyond bubbles and busts, oil should sell at its marginal cost of production, plus some profit."

    If this were true, gold would trade in the $300 - $400 range, or closer to its "marginal cost of production."

    The question is not what does oil cost to produce, but what is it worth?

    Therein lies the rub.

  • Report this Comment On April 05, 2009, at 8:48 AM, ralphmachio wrote:

    Does anyone have input involving TUWLF, ROXIF, AFRNF, HTGLF? I was just wondering if anyone else had an opinion. I like them but I think there will be a pull back.

  • Report this Comment On April 05, 2009, at 5:04 PM, InTheLongRun wrote:

    The International Energy Agency's estimate of the long run marginal cost of oil production is worth reviewing. It is on p218 of the 2008 World Energy Outlook. (If you don't want to buy the PDF, a good library should carry it.)

    It shows that about 1.1 trillion barrels have been produced globally to date at a cost between a few dollars and $30 (2008 dollars). The Middle East & North Africa (MENA) hold another approx 1.3 trillion barrels of conventional oil available at costs of $10 to 30. There is another 0.9 trillion barrels of conventional oil outside MENA at costs of $10 to 40.

    Then you are into unconventional oil (deepwater, ultradeepwater @$35-65, enhanced oil recovery, $35-80 and arctic fields $35 -100) totalling about 0.67 to 0.77 trillion barrels.

    Next, about 1 trillion of extra heavy oil and oil sands at $40 to 80 per barrel.

    Finally oil shales, gas to liquids, coal to liquids: about 3.5 trillion barrels at costs up to $120 per barrel.

    But analysis of oil supply, demand and prices without so much as a mention of the role of the OPEC cartel is so simplistic as to call the entire analysis into question. The same applies to a discussion of the prospects of publicly listed oil companies without mentioning their number one problem: replacement of reserves. National oil companies dominate reserves, International oil companies are at severe risk of being squeezed into being mere service companies.

    Even if the price is high enough to justify expensive non-OPEC production (the forward curve currently curves strongly upwards to about $75 by 2017: historically this is very unusual), investors in these reserves are still exposed if the price falls to $40. This is the upper range of OPEC's costs, but probably below their own costs.

    Conventional supply/demand and marginal cost analysis is always extremely problematic in the oil sector.

  • Report this Comment On April 06, 2009, at 9:19 AM, colddrink73 wrote:

    One thing I would have to say after reading this is why is everyone only talking about major oil companys. If I was looking to make a play in the oil market, which at this time I am not. I would be looking at one of the smaller oil companys like Clayton Williams or one of the penny stocks with the companys who do rehabilitation on existing wells. The question I really have is why is no one talking about the ETFs that deal with oil like USO or XLE? I would rather use on of these then have to worry about a oil company mismanaging themselves see Enron. As for people like Laogao let me see some of these 200% returns you are talking about. But I notice you are using options. Hmmmm.... Take a look at RICK over the past month. I could not pick it on CAPS but I picked it up @ $2.95 a share and its up almost %100.

  • Report this Comment On April 07, 2009, at 12:27 PM, XMFkmoney wrote:

    If you are looking for information on small cap oil companies I would highly recommend reading the Motley Fool's UK investment site.

    Their discussion board under sectors & general shares/ oil and gas companies is probably the premiere oil small cap investing community in the world.

    http://boards.fool.co.uk/Messages.asp?bid=50029

    First, they have really good explanations on how to value small cap oil companies. The gist of it is pretty simple. It's an asset play where you calculate the number of barrels a company has found times the price of oil. Obviously there's more money to be made before the companies make a new oil find so when valuing the company you adjust for the likelihood of finding the oil. Be prepared for a lot of math (or "maths" as they call it).

    Second, these guys have been around and doing this for a long time. It's one of the oldest UK boards and the leaders all pretty sophisticated investors.

    Third, and most importantly, they attend pretty much every major small cap oil shareholder meeting and ask questions from the community. Then they report back on it for discussion and analysis. It can be dense, but you won't get any better information.

    One warning, be prepared to wade through a LOT of acronyms.

    In short, it's pretty much exactly what you hope and expect to find at the Motley Fool.

    Fool on,

    K$ (ex UK-Fool)

  • Report this Comment On April 08, 2009, at 4:37 PM, KKnese wrote:

    Neither the article nor the comments address oil as a commodity, only oil as a stock. I was in college, learning to be wise, and our finance class was given 10,000 in play money and told to make ten imaginary investments, checking prices in the Wall Street Journal. I tried "investing" in oil futures back in 1987 and got clobbered. Lesson learned. Commodities futures are best used as hedges by people who really need them. They'll burn everybody else.

  • Report this Comment On April 09, 2009, at 3:42 PM, scambo99 wrote:

    7 funds and they finally got one in the green. Of course the other 6 are down between 12 and 35%.

    The one that is up is up 9.16% but they claim it is beating the S&P by 36.42% because the S&P is down 27.26%. So add their up of 9.16% to the down of the S&P of 27.26% and you get the fact that they are beating the S&P by 36.42%. Must be the new math.

  • Report this Comment On April 09, 2009, at 9:21 PM, Sam4th wrote:

    What always seem to be overlooked is that the world is not really a stable place and there will be, soon probably, some dramatic occurrence that will catapult both oil and pms well beyond what a rational lineal economic process would normally go in. It started last spring as an opening salvo.

    We'll see some event, or series of events soon that will trigger panic. .What is not that predictable but that it will happen is. We no longer live in the 50's. The world, and esp the US has changed and not for the good.

    I've been playing with penny nat gas/oil explorers and junior miners.

    Look into exxi, gsx, cfw and ivan on oil. Rby, uxg, mneaf and tgb on mining.

    do your own dd.

  • Report this Comment On April 09, 2009, at 9:39 PM, beaconps1 wrote:

    The rules of supply and demand for energy are no longer valid, if they ever were. The demand for oil is relatively inelastic and the supply is easily manipulated. The question is, what is it worth, how much will people pay? Four dollars a gallon brought the economy to a halt. The price will settle at a point that is perceived as affordable yet encourages the purchase of hybrid and 40 mpg cars while not discouraging other spending. Wages will be stagnant for another ten years, people will be happy to have job. I reckon that price will come in at 2.75 to 3.25 once the economy has recovered a bit. The economy may reset to 2004. Back then June gas was outrageously high at $2 a gallon but nobody was begging for 40 mpg cars or hybrids.

  • Report this Comment On April 09, 2009, at 11:27 PM, burferd1 wrote:

    I have been an oil exploration geohysicst for 35 years.

    I was fired when my company got bought out in 1999 when oil was $9/bbl.

    What I know is that there is abundant oil in the US controlled territories if we want to drill for it.

    I was in an exploration group that was looking at ANWAR in the 1980's.

    I was also working on development of offshore California oil in the 1980's before the government shut that in.

    The potential is there. If we want energy independence based on our production capabilities, we can have it at any time congress allows drilling in the "FORBIDDEN" areas.

    However, with the current Green views, I suspect that we will return to high oil prices in order to make the Greener's concept of 'economically viable' alternative energy a reality - based in large part on the artifically induced price of oil beause of exploration restraints.

    For that reason alone, I believe that it is time to buy oil stocks.

    The current prices are too low to make alternative energy development viable.

    In order for the Greeners to force alternative energy, they need to drive the price of oil to a price where alternative energy is cost effective.

    The only fly in this ointment is if the Middle East oil sheiks want to flood the market like they did in the 1990's.

    I do not think that is realistic, because at that time, their objective was to shut in marginal US production - and they were very effective at doing that.

    Now, they want to capitalize on their resources, because they realize there is a finite limit to what they own - and a limited timeframe to take advantage of it.

    It is to their advantage to keep the price of oil up by limiting production - as long as the US is willing - and with the new Regiem, they are.

    Just my opinion.

  • Report this Comment On April 10, 2009, at 10:20 AM, gkirkmf wrote:

    Foolish Food for thought - a quote from Jim Kunstler -

    quote:

    "If the "quantitative easing" (money creation) and fiscal legerdemain (TARPs, TARFs, et cetera) happen to jack up the "velocity" of the new funny-money, and the world resumes its previous level of oil use, the price of oil would rise again -- this time astronomically because the previous crash of oil prices crushed the development of new oil projects to offset depletion -- and the global economy will crash again."

    There are those who believe that there is an infinite supply of oil, and those who use scientific principles and mathematic probabilities to explain that US oil production peaked in the early 70's, and that the world's oil production is at a peak now. I an choosing to follow the rational scientific methods vs. being a "believer". I am hedging my bets on oil, and buying "energy" instead of only oil.

  • Report this Comment On April 10, 2009, at 11:46 AM, tommybitt wrote:

    For me, oil is a hedge.

    just like gold and other commodities.

    I want to own some, but am not overwieghting my portfolio with them.

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