Time To Buy Oil?

by Todd Sullivan

In order to have this discussion, we have to do one thing first..... Stop calling it oil. As soon as the word is mentioned, people's emotions take over and rational analysis stops. Emotion is the enemy of any investor. When people either sell due to fear or make buying decisions out of greed, the results are seldom stellar. This is exacerbated when the discussion turns to oil. The conversation will inevitably turn from oil fundamentals to conspiracy theories about Bush keeping the price of oil high to help his "oil buddies," the oil companies manipulating the price of oil for profits, the Saudi's funding terrorists with oil profits, Iran building "the bomb" with oil money, the drilling, refining and use of oil is ruining the environment (the irony here is that the oil industry argues that corn-based ethanol is more harmful to the environment, but that's another post) and the list goes on. In order to have a conversation that allows us to get anywhere, we need to strip away the fear.

This will allow us to see "what is" with oil and come to decision based on value. We can then add the fear back in to see its effect on the market. In the oil markets, fear has the inverse relationship that it does in the stock market. When fear in stocks drives their prices down; fear in the oil markets drives its price up. So, let us refer to oil as wood blocks [WB]. There is a worldwide market for WB. As a matter of fact, people cannot live without them. They use it everyday in their life and there is no widespread substitute for it. Now, the supply of wood for the blocks is finite, it is very expensive to get and the easy access to it is diminishing, causing only the more expensive wood to be available. Once we get the wood, we have to process it into blocks. There are only so many centers in the U.S. to process the wood into blocks, so we have a finite capacity to supply the finished products despite growing demand (there are no plans to expand this capacity anytime soon and as a matter of fact, it has not been expanded in over 30 years). As developing countries grow, their demand for WB is growing exponentially along with them. This puts more strain on the supply - demand equation that is currently just about equal (meaning our supply is about equal to demand).

Now as we look at the market for wood and its blocks, we really cannot see downside price risk for it. Right now the market is at equilibrium and the supply - demand equation tilts toward demand overcoming supply, which will lead to a price increase. When you have growing demand and a supply that is virtually maxed out you must have a price increase for the product, whatever it is.

Back to reality. Let's talk about oil. The fundamentals of oil dictate a price increase in the future. But, if we want in invest in oil, we must do so at a time when the fear factor of it has moderated and the "fear premium" is mitigated in its price. In the spring of 2006 oil prices surged past $70 a barrel. The fears that drove it was a hurricane forecast that predicted a hurricane season greater than the 2005 one, which crippled refining and drilling capacity in the U.S., tensions with Iran (the second largest OPEC producer) were escalating and fears grew that they would restrict oil from the market, and the U.S. was rapidly filling its strategic oil reserves (adding to demand) after they were irresponsibly depleted in the 90's (this artificially lowered the price of oil in the 90's as it dumped an excess supply on the market).

What has happened since then? The hurricane season was not only not as bad as 2005, but was one of the most benign in history (betters should get these folks' Super Bowl prediction and bet the opposite). Iran is still making threats to destroy the western world and Israel, but it is doubtful it actually has the ability to so. This has caused the world to just stop listening to President Ahmadinejad's rantings. If I tell you the first day of school I am going to bring a stick in tomorrow and beat you with it, you would be scared. After months of making these threats and failing to produce the stick or even try to beat you, your reaction would be to dismiss me as a nut. It is no different with world leaders (It reminds me of the old SNL skit about "Generalissimo Fransisco Franco is still dead" substitute "President Ahmadinejad's today again promised to destroy the world").

Add to this the realization that Iran cannot restrict its oil from the market. Its economy relies wholly on oil revenues and even with oil at$70,it is struggling. While a prolific producer of oil, Iran has no ability to refine it into anything. It relies on the rest of the world to do it and ship it back to them. Result? When it comes to oil, with our reserves now filled at 700 million barrels, up 160 million barrels from when George Bush took office (he has asked congress to double this capacity), they need us more than we need them when it comes to oil.

How is that, you ask? Iran produces about 14% of the world's oil. We currently have 57 days of total U.S. imports in our reserves. If we import from Iran at same percentage as they produce for the world markets, what would their elimination of oil exports do to our reserves and how long could we go without? I will use this 14% for the comparison, the actual amount may be more or less but there would be vast debate on it were I to "assume" a number. If we released oil from the strategic reserve to eliminate the effect of Iran's stoppage, in 406 days the reserves would be empty. Iran's economy would have collapsed well before then. Translation? This threat is a non issue. Would it be easy and pleasant? No, but they have far more to lose in this scenario. We would survive this event; they would not.

If you want to invest in oil, I would argue it is fairly priced now. We have had a very mild winter, the Iran issue has subsided, the reserve is filled and hurricane season is six months away. We are in a lull in the "fear factor" for oil. The price has cooperated and fallen to around $50 a barrel and bounced around there for a while now. Even the announcements from OPEC that they will cut production has only lead to small price increases. What does this tell us? The supply demand equation is equal - the diminished supply from OPEC is being offset by the diminished demand from the mild winter. $50 seems to be the "fair value" of oil.

So, how to get in? You could buy stock in one of the oil majors, Exxon (XOM), Chevron (CVX) or BP (BP) but I would advise against it now. Why? One word, Democrats. They are in charge of congress and love to vilify oil companies. They will take aim at them and try to grab their profits where they can. Until this issue is settled I would avoid these stocks. It may amount to nothing, but why risk it? If you want to go the oil route go with USO, the US Oil Fund ETF. It tracks the cost of a barrel of oil.

Caution: Oil is very volatile, especially when supply and demand are equal. Picture a piano wire pulled tight: if you hit the wire you get a sound, and the harder you hit it the louder the sound. That sound is the price movement of oil. Impacts (news events) will make the price jump either way, at times dramatically . You must set your time frame and parameters for the investment. If you are long term (years), you are really only looking at supply and demand, as long as it does not change from its current long term trend, the price must go up. There will be daily or hourly prognostications that will make you doubt your choice. Just stay focused and ignore the noise.