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Why Oil Prices Will Rise Again

By Bruce Jackson – Updated Apr 5, 2017 at 8:32PM

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Oil's a bear right now at $70 a barrel, but we'll see the bull's horns 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 [email protected], 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.

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Stocks Mentioned

The Goldman Sachs Group, Inc. Stock Quote
The Goldman Sachs Group, Inc.
GS
$293.05 (-1.03%) $-3.06
Chevron Corporation Stock Quote
Chevron Corporation
CVX
$143.67 (-0.76%) $-1.10
Exxon Mobil Corporation Stock Quote
Exxon Mobil Corporation
XOM
$87.31 (-1.54%) $-1.37
Contango Oil & Gas Company Stock Quote
Contango Oil & Gas Company
MCF

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