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 -- the holding company he runs. In his own words: "I bought a large amount of ConocoPhillips 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.

Despite a recent run-up, the price of oil is currently in the $50s per barrel, and ConocoPhillips' stock price has tanked in lockstep with the oil free fall. 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 almost 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 about five 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 technology made by LDK Solar (NYSE: LDK  ) and SunPower (Nasdaq: SPWRA  ) 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, BP (NYSE: BP  ) , and Royal Dutch Shell (NYSE: RDS-A  ) 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.

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 -- from manufacturers like Ingersoll-Rand (NYSE: IR  ) to retailers like Wal-Mart (NYSE: WMT  ) to airlines like AMR (NYSE: AMR  ) -- 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.

This article was originally published April 3, 2009. It has been updated.

Anand Chokkavelu owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Stock Advisor pick. Berkshire Hathaway and Wal-Mart Stores are Motley Fool Inside Value picks. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (12)

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  • Report this Comment On May 12, 2009, at 7:43 AM, DanCorp wrote:

    Other factors of interest I'd like to see discussed;

    Is it true that the more Arabic nations contain their own economies, the less dependent they are on volume sales of oil and the more they can collectively constrict supply to push up prices (taking the gamble I guess, they won't be invaded!)?

    Also, what would be the effects of the Russians setting-up their own global energy market to compete with the US markets and sales of oil by $USD? There own currency may not be ideal (maybe Euro's or even Yuan) but never understood why the Russia with it geography, natural reserves and infrastructure hasn't done this ...sure it isn't to avoid upsetting the USA.

    Whilst alternative fuels may have niches, can they really be expected to cover infrastructure demands before oil 'dries up'?

  • Report this Comment On May 12, 2009, at 8:15 AM, ngass wrote:

    Unfortunately the use of alternative energies on a grand scale is far off. So, oil and NG are our only big energy sources. Daily, a number of comments are made on the future of crude oil prices. Last week, for example, an investment firm said that they have shortened crude oil for a strike price of $30! Others muse about crude oil prices above $300 in 2020. Fact is that crude oil is depleting. The Saudis have employed more and more rigs on their largest field Ghawar, an indication that production is falling. Cantarell, the largest oilfield in Mexico is depleting over 7% per year and some oil rigs off the coast of Scotland were already dismantled. That seems to be the beginning of global peak oil.

    There is a thesis on the history and future on crude oil prices entitled: Understanding Crude Oil Prices You can skip the math and read the text and especially the charts. I find the math a bit weak since there is very wide gap between the minimum and maximum price as, for example, 2010: $48 - $273. One does not need any math to state such a range.

    I did not wait for all these gurus to waffle about oil and bought SU, CNQ, COS,UN, ECA in March since I believe in the demand shortage of oil in future.

  • Report this Comment On May 12, 2009, at 9:47 AM, dp23peace wrote:

    I have read extensive reports on oil from the IEA and others, not from an investing perspective, and it's clear oil consumption will go up, and as you mentioned prices WILL go up. We can devise every alternative we want, but through 2030 we are going to still be using oil more than anything else.

    My way of playing this is to get it from a few angles;

    BP - I love them because not only are they a huge player with more room for growth than Exxon, but their Solar division is the best and has an extensive contract with Wal-Mart to put solar on all their rooftops. A dual-play

    MarkWest Energy (MWE) - they move the oil around, and have many collaborative efforts in the US that will take advantage of shale, and natural gas too. Oh, and they are an MLP with a 28% dividend.

    Dawson (DWSN)- they provide the seismic data to drillers so they know where to drill - the demand for this is going to increase as oil becomes harder to find.

    Wilderhill Clean Energy (PBW) - strong fund that will go up as we use more alternative. A good hedge bet.

    So far;

    BP + 15.26%

    DWSN +77.45%

    MWE + 52.76%

    PBW +39.65%

    If I had oil picked big oil I would be laggin the market at 15%. My hope is that this collection will support each other at different times, but always be spanking the S&P.

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