Oil


Few inputs impact the world economy like the price of oil. Oil powers cars, trucks, boats, airplanes, and even power plants that make up the backbone of the global economy. As oil prices rise, costs go up for transportation companies, squeezing their profit margins and forcing them to raise prices, similarly affecting all the other companies that rely on them to transport products and people. By contrast, most energy companies benefit from higher oil prices, either from higher revenues for oil, or because of increased demand for substitute energy sources such as ethanol and natural gas. The extreme volatility of this important economic input has piqued interest in issues like peak oil, speculation, and the world's rising energy appetite, and is leading to greater investment in renewable energy.

The United States is the world's largest importer of oil, with the Top 5 sources by country (US Census) being: 1) Canada, 2) Mexico, 3) Saudi Arabi, 4) Nigeria, 5) Venezuela. It wasn't always this way! The Industrial Revolution and the US' standing as an economic superpower was built to a great extent on the availability of cheap and abundant energy. Going into the 20th century, new oil discoveries from Pennsylvania to Texas to California resulted in the US becoming the world's largest producer and exporter of oil at the time. Oil quickly displaced other energy sources like kerosene and coal, and many "American Dreams" of fortune and happiness were fulfilled or lost in the pursuit of oil.

The Standard Oil Trust was so big that if it was still together today, and John D. Rockefeller still alive, he would still be the world's wealthiest man; worth more than several of the top wealthiest people today - combined! Exxon, Mobil, Chevron, Sohio, Amoco, Conoco and Arco were some of the companies that made up this monolithic oil trust. In 2012 Exxon Mobil (NYSE: XOM) alone is the world's most profitable company, and was also the largest by market capitalization until Apple (NASDAQ: AAPL) took the top spot in 2011.

Back in the early 1900's the EROEI, or "Energy Return On Energy Invested", was around 300 barrels for every barrel invested. By the 1950's the EROEI was down to 30 to 1, as most of the world's cheap, light, sweet, oil reserves were starting to run dry. Today, the return on most tar sands projects is only in the single digits, with many as low as 1.5 to 1. At 1 to 1 it will just sit there, as it won't be economical to produce at any oil price! The point being, no matter how much oil we believe there still is, we need to all agree that cheap oil is gone forever!

Oil Prices


Light Sweet Crude Oil futures contracts are traded on the NYMEX under ticker symbol CL, priced in USD per barrel for delivery in all months.

Rising oil prices pose challenges for many companies as well as consumers, which is why rising oil prices are damaging to the economy.

  1. Rising oil prices increase costs for many companies. These costs may be difficult to pass on to customers, who are loathe to pay more for the same goods, thereby eroding profit margins.
  2. Rising oil prices reduce consumer demand for products that consume oil.
  3. Rising oil prices make travel and shipping more expensive.
  4. Rising oil prices cause increased interest in electric vehicle conversion and energy alternatives in general.
Due mainly to growing demand from emerging economies such as China and India, the price of oil moved steadily higher from the turn of the 21st century until July 3, 2008 when it peaked at a record high of $145.85 USD per barrel. Oil prices then plummeted all the way back to under $40 per barrel by the end of that year, a result of economic pressures from the Credit and Financial Crisis which led to a global recession.

As the global economy started recovering in mid 2009, oil prices moved higher again. Oil prices were over $80 a barrel early in 2010 as news broke about the sovereign debt crisis in Europe. The economic fallout and potential recession impacts from these so-called PIIGS countries (Portugal, Ireland, Italy, Greece, Spain) have created much volatility in stock, bond, currency and commodity markets worldwide that are still being felt today. In 2011 several European sovereign debt ratings were downgraded, and even the US lost its S&P AAA rating. Government changes in Greece and even France were blamed on new austerity measures, that citizens resisted by voting against politicians who support the severe cuts needed to balance budgets and to remain in the European Economic Union.

Despite sharp short-term pull-backs, oil prices were again above $100 per barrel going into 2012. Oil prices will remain volatile as the European and US debt situations get worked through, and as the recession impacts on growing economies that are dependent on international trade are felt. Oil demands and prices depend on the health of the global economy, about as much as the global economy depends on the supply of reasonably priced oil. Geopolitical shocks can also affect oil prices, something to keep in mind going into the US presidential election with the Iranian nuclear and Syrian uprising situations unresolved.

Spot Prices versus Futures Prices


Spot prices are the prices paid for oil here and now - as in the amount of money you would hand a producer in exchange for their tossing a barrel of oil into the back of your truck. Futures prices, on the other hand, are the prices paid for contracts promising the delivery of oil at a future date. Whether or not the prices of oil futures affect spot prices is one of energy economics' most prevalent modern debates.

Moreover, there really is no "true" spot market for oil, in the sense of that there is a "true" spot market for stock or other financial assets. A "true" spot market requires, as described above, the actual physical transfer of the goods, to the purchaser, directly at the time of purchase, and there simply are no large scale sellers of crude oil, that operate in such a fashion. The "spot" prices that are quoted, involve the transfer of 1000 barrels of crude oil, not one or two. That would require literally 5 of 6 tractor-trailer rigs to carry off back to your house: the transportation costs would approach the value of the oil itself. When one speaks of a "spot" price for crude oil, one is meaning the current trading price, of the next future contract that will come due.

Those that claim that futures prices (and, therefore, speculation) do not affect spot prices argue that people who purchase futures contracts do not actually purchase any real oil. When a fund purchases a futures contract and that contract comes due, it must sell the oil to someone who will actually use it, because that fund has no way of actually keeping the physical product. This means the oil must come to market - no matter what the price. If a firm buys a $150/barrel futures contract in June for July and the spot price in July is $140, the firm must buy the oil at $150, and then it MUST sell the oil at $140, because it can't actually hold the oil. This means there is no accumulation of oil - firms can't hoard oil, so they can't actually affect the present market. Therefore, it is argued, the prices of futures contracts have no affect on spot prices.

Those that believe futures speculation has an effect on spot prices (at least, those with a sound understanding of economics) argue that when oil futures are traded, oil purchasers, like refiners, try to buy oil at prices that will benefit their margins in both the short and long term. If it is believed that oil prices will rise in the future (indicated by futures prices being higher than present prices), purchasers will want to stock up on oil at lower prices today and put it in inventory; this drives up demand for crude in the present, forcing oil prices up in the present. Thus, it is argued, high prices for oil futures leads to high prices for oil in the present.

When the future price of a commodity like oil is higher than its present price, known as Contango, it is more profitable for a commodities producer like Chevron (NYSE: CVX) to store oil and sell it at a later date. This causes oil price volatility through various channels: for example, storage of a commodity causes supply to be reduced in the present, raising spot prices, while expectations regarding future supply increase - thereby reversing the cycle, which then causes contango all over again. The wider the spread between the present price and a future price, the heavier the contango and the volatility.

The opposite market condition to contango is known as Backwardation.

Who Wins from Rising Oil Prices and Loses from Falling Oil Prices


  • Alternative energies like wind, solar, and geothermal, as well as alternative fuels like biofuels, ethanol, cellulosic ethanol, and fuel cells all see increases in demand when the price of oil, their main competitor, increases.
  • Coal companies like Peabody Energy (NYSE: BTU), Arch Coal (NYSE: ACI), Consol Energy (NYSE: CNX), and Massey Energy Company (NYSE: MEE) see sales growth, as rising oil prices cause consumers to demand more local sources of energy; the U.S. is the world's second largest coal producer, after China, and there are estimates stating that U.S. coal deposits have more energy than the world's remaining oil reserves. Note: Massey Energy was acquired for $7.1 billion by Alpha Natural Resources (NYSE: ANR) in 2011.
  • Hybrid car manufacturers like Toyota (NYSE: TM), Honda (NYSE: HMC), General Motors (NYSE: GM), Ford Motors (NYSE: F), and Nissan (OTC: NSANY) benefit from higher oil prices because high oil prices lead to higher gas prices, causing consumers to seek out ways to reduce the amount of gasoline they use. Auto makers that have announced plans to produce electric cars also can benefit, and will if oil prices start to rise again over the next few years; these companies include Daimler (OTC: DDAIF), Renault (PARIS: RNO), Toyota, General Motors, Ford, Mitsubishi Motors (OTC: MMTOF) and Tesla Motors (NASDAQ: TSLA). Companies that produce electrical storage systems and other alternatives to power vehicles, like hydrogen fuel cells, also benefit, such as Ballard Power (NASDAQ: BLDP)(TSX: BLD) and ZENN Motor Company (TSXV: ZNN)
  • Independent Oil & Gas companies benefit the most from high oil prices, as they can extract crude at a relatively constant cost from a reserve, but sell it at higher and higher prices. The higher the price of oil, the larger an E&P company's margins.
  • Oilfield services see dayrates (and, thus, margins) skyrocket, as upstream oil companies scramble to increase production, causing demand for drilling rigs and other oilfield services to go through the roof. Machine tools & accessories companies also benefit, as they sell individual parts to oilfield services companies that build, retrofit, and repair rigs.
  • Deepwater drilling contractors like Transocean (NYSE: RIG), Diamond Offshore (NYSE: DO) and SeaDrill (NYSE: SDRL) are even better off than their peers in the oilfield services industry; there are far fewer deepwater rigs in the world than normal rigs, and with conventional wells drying up, oil companies have been willing to pay more to get at the difficult-to-reach reserves. Before the oil price collapse in the middle of 2008, floating offshore rigs could go as high as $292,000, while deepwater oil exploration rigs were contracting at above $800,000 per day.
  • The oil majors are the very largest of the non-national oil companies, and are vertically integrated. These companies explore for and produce crude oil and natural gas; they transport it by pipeline and tanker; they refine crude oil into finished petroleum products; and they also market crude oil, natural gas, and refined petroleum products to industrial users and retail consumers. The majors get most of their money from selling refined petroleum goods; vertical integration allows them to sell high-priced crude to themselves at production costs, causing the margins on these goods to go through the roof. Often, however, they must buy crude to supplement their own production, as their refining capacities are greater than their upstream production. This offsets some of their profitability.
  • With the price of oil having been above $100 per barrel, the world's waste management companies like Waste Management (NYSE: WM) and Republic Services (NYSE: RSG) are considering "landfill mining", as high-quality polyethylene prices have doubled since the summer of 2007, making the world's trash landfill operators' a treasure.
  • Some chemical companies, like Sociedad Quimica y Minera S.A. (NYSE: SQM), Terra Industries (NYSE: TRA), CF Industries (NYSE: CF), Agrium (NYSE: AGU)(TSX: AGU), and Potash Corporation of Saskatchewan (NYSE: POT)(TSX: POT); these companies produce chemicals like fertilizer, the demands for which increase when oil prices rise due to increased demand for biofuels that need such agricultural chemicals. Note: CF Industries acquired Terra Industries in 2010.

Who Loses from Rising Oil Prices and Wins from Falling Oil Prices


  • Oil & Gas Refining & Marketing companies buy crude oil, process it, and sell the processed product to the end market. Companies like Sunoco (NYSE: SUN), Valero (NYSE: VLO), and Western Refining (NYSE: WNR) are all prolific U.S. refiners. When these companies must purchase crude oil at a higher price, they then have to sell the refined product (gasoline, jet fuel, diesel, etc.) at a higher price, which then causes demand to drop as people travel less. Furthermore, refined goods prices rise by a smaller amount than crude price. At the end of the 1990s, oil traded below $20/barrel, while gasoline cost under $1.50/gallon. In June 2008, crude traded at around $121 (after rising to over $135), while gasoline averaged $4.10. Oil prices rose by a factor of six, while gasoline prices rose by less than a factor of three. The clear losers, in this case, are the companies that make and sell gasoline, though when oil prices fall, they fall further than gasoline prices, making refiners the winners.
  • Shipping companies are harmed by higher oil prices because oil is necessary to operate the planes, trucks, and ships that transport goods around the globe. These companies include brand-name shipping companies like FedEx (NYSE: FDX) and UPS (NYSE: UPS), industrial shipping companies like TNT Express (acquired by UPS in 2012) and Con-Way Trucking (NYSE: CNW), and international shipping companies like Teekay Shipping (NYSE: TK) and Frontline (NYSE: FRO). Less-than-Truckload LTL trucking companies, however, are relatively shielded from fluctuations in diesel fuel prices, as the industry generally passes on fuel price surcharges to its customers like Wal-Mart Stores (NYSE: WMT). Also, aircraft leasing companies such as Aircastle (NYSE: AYR) are hurt by rising oil prices.
  • Airlines like Delta (NYSE: DAL), Northwest (NYSE: NWA) (acquired by Delta in 2008 for $2.8 billion), United Continental (NYSE: UAL), American Airlines (NYSE: AMR)(OTC: AAMRQ), US Airways (NYSE: LCC), Southwest (NYSE: LUV), JetBlue (NASDAQ: JBLU), Air Canada (TSX: AC.B) and WestJet (TSX: WJA) etc. are harmed by rising oil prices. In the past, jet fuel has accounted for 10-15% of an airline's cost, but by mid-2008 they made up 30-50% of costs, albeit before the price collapsed below $50/barrel. Airlines in general have been disasterous long-term investments! Many of these established household names are now the result of recently forced buyouts or mergers, or after emerging from or near bankruptcy.
  • The lodging, hospitality and entertainment industries see declines in customer counts, occupancy rates and revenues when oil prices rise, as higher travel prices cause fewer consumers to take vacations, gamble at casinos, or go to restaurants. Most businesses are affected, from Hyatt Hotels (NYSE: H) to casino resorts like Las Vegas Sands (NYSE: LVS), to all kinds of restaurants from fine-dining to casual dining like McDonalds (NYSE: MCD), to even coffee chains like Tim Hortons (NYSE: THI)(TSX: THI).
  • Other vacation and travel alternatives like cruise lines Royal Caribbean Cruises (NYSE: RCL) and Carnival (NYSE: CCL) see higher fuel costs, forcing them to raise prices and drive potential customers away.
  • The Chemical industry is harmed by higher oil prices because petroleum is a key ingredient in plastics. As the price of oil rises, plastics become more expensive to produce, causing margins to shrink.
  • The retail industry is harmed by rising oil prices because shipping companies charge higher prices, making it more difficult for retailers to get their products to market and forcing them to raise prices. Discount retailers, including Family Dollar (NYSE: FDO), Dollar Tree (NASDAQ: DLTR), Big Lots (NYSE: BIG), Wal-Mart (NYSE: WMT), Target (NYSE: TGT) and Dollar General (NYSE: DG) are exposed as their consumers generally have lower incomes, making them more sensitive to rising energy prices. Entertainment venues and especially restaurants "feel the pinch"; finding it difficult to pass on higher agricultural and packaging costs at the same time people have less to spend and are driving less.
  • Online retailers that subsidize the cost of shipping, like Amazon.com (NASDAQ: AMZN) and Overstock.com (NASDAQ: OSTK), are forced to pay part of the shipping price increases, causing margins to shrink.
  • Car companies that are heavily dependent on sales of SUVs for profits, such as General Motors (NYSE: GM) and Ford Motors (NYSE: F), see fewer sales as consumers tend to reduce their purchases of "gas-guzzlers" when oil prices are high.
  • Automotive parts retailers like AutoZone (NYSE: AZO), Advance Auto Parts (NYSE: AAP), and O'Reilly Automotive (NASDAQ: ORLY), who depend on heavy driving and automotive wear-and-tear, struggle when drivers conserve due to high oil prices and demand fewer repairs.
  • Automotive retailers like AutoNation (NYSE: AN) and CarMax (NYSE: KMX) depend on replacement demand for new cars due to wear-and-tear, which decreases as fewer people drive.
  • Agricultural production companies must absorb the increased cost of oil derived products, such as fuel, fertilizer, and plastic products. This decreases a company's net profit and increases the price of food for consumers.
  • More and more people are looking into electric vehicle conversions as a way to get off gas all together, without buying a new vehicle. Conversions are getting more range than factory built electric cars at a lower cost. It is growing by leaps and bounds in the U.S.
  • Chinese manufacturers lose their low-cost production advantage, as rising oil prices cause the prices of whatever is being shipped from China to be artificially inflated. Lower oil prices, at around $20/barrel, were equivalent to low tariff rates (about 3%); however, oil prices during the 2nd quarter of 2008 were the equivalent of a shipping tariff rate at around 9% and rising (until the bubble burst).

Crude Oil Classifications


Oil is generally classified based on it's density and sulfur content. The density of oil is normally reported according to it's API Gravity in conformance with standards set by the American Petroleum Institute (API). API Gravity is a type of dimensionless number and therefore, does not have any specific units, although gradations on the API density scale are commonly referred to as "degrees" in oilfield vernacular. Since the scientific difference between density and it's more commonly understood "cousin," weight, is not widely understood, oil density is often mistakenly referred to as weight, and instead of "low density" and "high density" oil, the accepted practice is to talk about "light" or "heavy" oil.

Light vs Heavy Crude

  • Light crude has low density making it easier to transport and refine. Light crude is chemically "closer" to many desired finished products such as gasoline and diesel fuel and as such usually requires less refining and processing and therefore is typically more valuable and more expensive than "heavy" oil.
  • Heavy crude has high density, making it more difficult to transport and refine. Heavy crude is cheaper to buy and usually cheaper to extract, though heavy crude produced from tar sands can cost twice as much as conventional drilling.
Heavy crude oil is typically defined as having a specific gravity greater than .933; however the distinction is often more functional than empirical, with any crude being labeled "heavy" that does not flow as well as its light counterpart.

Sweet vs Sour Crude

  • Sweet crude oil is oil with a low sulfur content (typically < 0.5%) which results in lower refinery costs and fewer impurities.
  • Sour crude has a sulfur content above 0.5% by weight, making it more expensive to refine, and therefore worth less per barrel.
While sweet crude is generally the crude oil refined into gasoline, some refining companies, notably Valero Energy (NYSE: VLO), have developed refining processes that allow them to refine more challenging, but cheaper, higher-sulfur petroleum.

Crude Oil Benchmark Blends


Crude oil is priced in terms of regional blends, each with different characteristics. Of these, certain blends are followed by traders, as they most reflect the overall value of oil, and therefore affect the way different blends are priced. These are essentially like a Consumer Price Index for different types of oil. There are about 161 different types of crude that are traded around the world; the four primary benchmarks, of which these are priced internationally, are Brent Crude (NYME: BZ), West Texas Intermediate (NYME: CS), Dubai, and the OPEC Basket.

  • Brent Blend: Based on the prices of Brent Crude (NYME: BZ); a light, sweet crude, from 15 different oil fields in the North Sea.
  • West Texas Intermediate WTI (NYME: CS): The benchmark for oil prices in the US based on light, low sulfur WTI crude. WTI remains the benchmark for oil prices in the US despite the fact that its production has been falling for years.
  • Dubai: Dubai crude, from Dubai, is a benchmark for Persian Gulf crudes, and is light yet sour.
  • OPEC Basket: The OPEC crude basket is OPEC's benchmark, and is made up of 13 different regional oils: Algeria's Saharan Blend, Angola's Girassol, Ecuador's Oriente, Indonesia's Minas, Iran's Iran Heavy, Iraq's Basra Light, Kuwait's Kuwait Export, Libya's Es Sider, Nigeria's Bonny Light, Qatar's Qatar Marine, Saudi Arabia's Arab Light, the United Arab Emirates' Murban, and Venezuela's BCF 17.

Shifting Oil Dynamics - Relying more on Canada


Where oil is coming from is changing. In 2010, according to the US Energy Information Administration, the top five oil suppliers to the United States were (from highest to lowest) Canada, Mexico, Venezuela, Saudi Arabia and Nigeria, this represented 59% of all imports. Canada is rising and Mexico and Venezuala are falling.

In Canada the Athabasca oil sands reportedly hold 1.7 trillion barrels of oil. Currently 1.25 million barrels are extracted daily from the Canadian oil sands and one million goes directly to the US. 16% of US oil imports come from Alberta and it will only continue to grow. The oil majors BP (NYSE: BP), Royal Dutch Shell (NYSE: RDS.A) and Exxon Mobil (NYSE: XOM) have committed $125 billion to production in Alberta over the next 20 years. Total US imports from Alberta are expected to reach 5 million bbd, according to the National Resource Defense Council, by the year 2020.

This means big opportunities for Canadian oil companies and others with a strong presence in oil sands. With the US trying to ween itself off of OPEC countries, its own supplies are slowing and its neighbors to the south are drying up. Watch as Canada reaps the benefits. Companies like TransCanada are already investing heavily with a $7 billion pipeline expansion that would run 1,800 miles of pipe into the US and double its exports to the US to 1.1 million barrels per day.

Continued Push for Domestic U.S. Oil


President Barack Obama announced on March 31, 2010, that he would open up large swaths of the Eastern Seaboard to off-shore drilling. The proposal allows companies to lease land and drill for oil and natural gas from the tip of Florida to the northern end of Delaware, as well as certain locations in the Gulf of Mexico and by Alaska. The proposed bill would still protect regions that are considered to be delicate, and all drilling would take place only after research to determine the effect on the environment. Already the bill has been met with resistance by Republicans who say it does not go far enough, and with harsh criticism from environmentalists. The additional areas in the Gulf of Mexico could hold up to 3.5 billion barrels of oil and 17 trillion cubic feet of natural gas, but the start to any such drilling would still be several years off. This move by the U.S. government demonstrates its efforts to drive domestic oil production and decrease its reliance on foreign oil.

And don't forget the Bakken formation in Montana, North Dakota, and Saskatchewan holding promise of billions of barrels of oil production.

Why Oil Prices Rise or Fall


IEA Outlook Stresses Increased Output

According to the IEA, global output of crude needs to increase significantly in 2011 in order to meet faster-than-expected oil demand growth. In its January report, the IEA increased its estimated demand for 2010 and 2011 by 320,00 barrels/day. As of January 2011, the IEA predicts a rise in demand of 1.4 million barrels a day in 2011 compared to estimated 2010 levels.

The direct consequence of tighter oil supplies is higher crude prices; which the IEA believes will stymie the global economy. According to the IEA, if oil prices remain at $100/barrel in 2011, global expenditures have the potential of rising to 5% of GDP, a level associated with economic problems in the past. The IEA plans to pressure OPEC to lift its production ceiling as a result of these findings, but OPEC has disagreed with the IEA's predictions. While the IEA believes that global inventories are not sufficient to meet demand without an increase in production levels, OPEC believes the IEA's estimates of inventories are incorrect and does not expect as drastic an increase in demand relative to supply as the IEA does. Nevertheless, global production levels have the potential of being crucial to the future price stability of crude oil.

Lagging Economies Across the Globe Contribute to Declines in Oil Demand

Concerns about the European debt crisis, China's growth outlook and the entire global economy has led to questions about energy growth and demand through 2010. Analysts had previously predicted growing demand, however these factors contributed to the 3 month low for oil prices in the middle of May 2010. Also during May the EIA reported that crude stockpiles rose by 1.9 million barrels and were at 362.5 million barrels. Rising stockpiles is a sure sign of dropping demand.

According to the EIA world crude demand for 2009 was below 2008 levels, which were below 2007 levels. This is the first time that demand for crude oil has had two negative back-to-back years since the 1980's. However, in the future the EIA does expect demand to grow in 2010 and 2011 at 1.6 million barrels per day each year. Additionally, OPEC, which supplies 35% of the world's crude has predicted that oil demand will grow by 950,000 barrels per day in 2010. Though demand should rebound, its speed will be tied to factors such as the global economy, in particular the economies of large markets such as China.

Increases in Freight and Shipping Activity Boost Diesel Demand and Profits

About 9.6% more freight was moved by trucks in April 2010 than in the same period in 2009, which has led to an increase in the need for diesel fuel. Demand for the fuel increased 12% for four weeks ended June 11, 2010 compared to the same period in 2009. Prices have also improved: June 2010 prices are nearly double of their levels in June 2009. Due to a recovering economy, consumption of U.S. distillates are predicted to expand 1.4% this year, which is the largest annual increase since 2005.

The Recent Drop in Oil Prices Due To Demand Destruction

Demand destruction - primarily in the United States - is likely responsible for most of the drop in oil prices that occured during the third quarter of 2008. According to an Energy Information Administration (EIA) report, gasoline consumption in 2008 is expected to drop 3.4 percent, or 320,00 bpd, from its 2007 levels and continue to decline 0.6 percent during 2009. Furthermore, in the first quarter of 2008, trucking industry analyst Donald Broughton estimated that 42,000 trucks, over 2% of the United States' fleet, came off the nation's highways. With nearly 1,000 trucking companies filing for bankruptcy, the demand for diesel fuel has been slashed.

Much of this demand destruction is likely rooted in the 2007 Credit Crunch, the 2008 Financial Crisis, and the resulting recession; when unemployment rises, people stop spending and start saving. When people stop spending, companies stop producing. When companies stop producing, demand for energy falls. When demand for energy falls, the price of oil falls. Hence, it is likely that oil prices will remain down until the world economy recovers from its recession.

Don't Forget About Oil Supply Shocks!


Production Cuts

The global oil supply is dependent on the ability of oil companies to produce and the willingness of oil-exporting countries to export. Historically, periods of oil price spikes have been caused by oil-exporting countries placing embargoes on certain countries. In 1973, for example, the world's largest oil cartel, OPEC, placed an embargo on oil exports to the Netherlands and the United States, in response to the countries' support of Israel in the Yom Kippur War; the price of oil acquired by refiners increased by approximately 100%, and the U.S. experienced widespread shortages. In 2007, however, despite a 57% increase in prices, the amount of oil exported by the world's top exporters fell 2.5%. Demand for oil in the world's six largest exporters (Saudi Arabia, United Arab Emirates, Iran, Kuwait, Iraq and Qatar) increased by more than 300,000 barrels, while their exports fell by over half a million barrels. In this case, growing demand in each company acted as a natural embargo, forcing them to meet their own needs before exporting to the rest of the world.

Violence Against Producers

Violence in unstable regions can cause oil prices to be volatile because of geopolitical events affecting the ability of upstream oil companies to produce. Terrorist and political attacks can damage drilling rigs or the transportation and refining networks -- including pipelines, shipping facilities, and refineries -- that bring oil from where it is extracted to the consumer. During the spring of 2008, for example, Nigerian rebels initiated attacks on the oil majors' pipelines and deepwater drilling rigs in the country. Despite the fact that OPEC's lead producer, Saudi Arabia, announced it would increase production by 2%, a rebel attack on one of Shell's deepwater rigs sent prices to $136.

Transportation Bottlenecks

When there are problems with the pipelines that transport oil, it can't get to market; this effectively reduces the supply of crude oil to the world's refiners, causing the supply of refined products to fall. When supplies fall, prices rise. On March 28th, 2008, the day after the bombing of one of Iraq's primary export charges, Brent crude rose on the London exchange by $1.01.

Peak Oil and Declining Production

Peak oil refers to the "peak" on the graph of global oil production. Oil must first be discovered, then produced, and will eventually be depleted. Peak Oil is not a theory. It is a fact. Oil has already peaked in the USA and more than 50 other oil producing countries. Oil has a finite supply, so, the same as the production of any geological commodity, oil production will graphically (mathematically) "peak" and then irreversibly decline.

Once the halfway point, or "peak", has been passed, production begins an irreversible decline (the production profile of the remaining oil is similar to the inverse of the first half of the production curve). Peak Oil is sometimes misunderstood to mean that "we are running out" of oil. However, the peak only means half of the oil has been extracted, while the other half still remains to be extracted. Many have speculated that as supplies decline, prices for oil will rise unless there are successful conservation efforts and/or new technologies developed that would mitigate the decline in oil supplies projected by peak oil theory.

The timing of the peak in global oil production is highly controversial because of the political and economic impacts expected from Peak Oil including the impact on the stocks of all companies in the global marketplace dependent upon oil for it's main source of energy. Many analysts believe Peak Oil is imminent, even though estimates of the exact year of the peak vary widely from 2010 to 2050 or beyond. However, some analysts, such as Matthew Simmons, have concluded that global oil production has already peaked.

Currently being analyzed and discussed is the issue of whether Peak Oil is being "masked" by the drop in demand due to the global economic crisis and that maybe the Peak is being shaped into more of a plateau. This would be similar to the Peak in US oil production that was predicted as early as 1956 and subsequently actually occurred in 1971, but was not confirmed until about 1974. The fact that the actual Peak cannot be accurately predicted, but will only be confirmed years later suggests that aggressive action should be taken to alleviate the economic and political impacts of Peak Oil well before the Peak. Unfortunately, it may already be too late to plan intelligently for Peak Oil impacts and the world now faces extreme distress, in securities markets and otherwise.

Theories that opening the Arctic National Wildlife Refuge and offshore drilling sites in the U.S. to development would alleviate gasoline prices are likely misguided; Jim Sweeney, director of the Precourt Institute for Energy Efficiency at Stanford University, says that offshore U.S. reserves would account for just 1% of worldwide consumption, but wouldn't be productive for 10-15 years.

U.S. Dollar Value Fluctuations Cause Positive Feedback on the Price of Oil

The United States imports much of its oil, and that oil is purchased abroad in U.S. dollars. The price of oil, in fact, is pegged to the dollar. The changing value of the dollar in comparison to other currencies impacts the price paid by end users. A strong dollar means a lower price, in dollars, for oil, and a weak dollar means more dollars must be spent to purchase the same amount of oil. Currency fluctuations are complex, but the value of a currency is impacted by the relative value of goods imported and exported by an economy (known as the trade balance), its interest rates, the size of its national debt, and its economic growth.

Severe Weather and Government Intervention

Strong hurricane seasons can damage offshore oil platforms, reducing the amount of oil produced. Cold spells increase demand from oil fueled furnaces, while hot spells increase demand from air conditioning powered by oil fueled electrical power plants. Supply can also be artificially reduced or increased by government taxes and subsidies on oil production, or by providing access to the strategic oil reserve. In short energy, and oil, affects everything!

And Speculation


Some analysts believe that oil prices are at record highs because of speculation about the future value of oil. Specifically, these analysts claim that the belief that the oil supply is lower than it is, and the belief that the future oil supply will be just as low, has led traders and even refiners to inflate the prices of oil futures. (See Spot Prices vs Future Prices above).

OPEC believes that record fuel prices are not a function of supply and demand, but a function of Western government policy and rampant speculation, and has used this belief as an excuse not to raise production by the amounts demanded by the West. While much of the data shows that production has been slowing, it's likely that speculation could account for some of the present price spikes.

When oil prices hit record highs five days in a row during the week of May 5th, 2008, a House of Representatives committee announced an investigation about the role of hedge funds and investment banks in pushing up prices. In June 2008, the U.S. commodities futures regulator announced new rules requiring daily large trader reports, and position and accountability limits for foreign crude contracts traded in the U.S.

Contango Causes Some Oil Price Volatility

In early March, 2009, an April 2009 oil delivery contract traded for $38.10, while an April 2010 contract traded for $50.26, making it $12.16 more profitable for oil companies to hold onto their oil until April 2010. Wide spreads between present and future prices can significantly increase volatility. (See Spot Prices vs Future Prices above).

Investment Strategies: Ways To Invest in Oil


1) Buy some dirt and drill a well

The "beauty" and ease of purchasing securities online to invest in lucrative commercial endeavors like oil production is best put into perspective by considering the history of the oil business and the extreme difficulty and risk of actually "investing" the time and effort to buy your own dirt and drill a well like the old timers did.

2) Private Placement

Investing in publicly traded energy industry securities, including oil and gas securities and related services companies, represents only a part of the total global investments made.

Arguably, the most lucrative way to invest in oil and gas is through a "private placement".

The general public does not receive information about private placements because these are a type of securities that carry a much higher degree of risk than publicly traded securities like Exxon Mobil (NYSE: XOM) and the like. The securities laws, both federal and state, prohibit what is known as a "general solicitation" in private placements. This means that PP's cannot be advertised, including any website open to the public, and, a telemarketing campaign cannot be utilized except to screened lists of qualified investors.

After the lessons learned from the 1929 stock market crash, the US government enacted various legislation to protect unsophisticated layperson "investors" from investments carrying inordinate risk. The Securities Acts of 1933 and 1934 created these protections.

Private Placements are unregistered securities that qualify for an exemption from registration.

Private Placements in oil and gas investment partnerships are only available to "accredited investors," a legal term carefully defined by the SEC.

Although there are a series of specific rules, generally, a person must have made verifiable income of at least $200,000.00 USD in the most recent two years and have a reasonable expectation to earn at least that amount in the current year. For married couples the "rule" is $300,000.00 USD between both spouses incomes (could be a $175k/$125k split or any other percentage split).

Private Placement investments in oil and gas drilling ventures carry a very high degree of risk, so the investor must have the financial means to withstand the complete loss of the investment without sustaining undue hardship.

These strict rules cut out approximately 91.53% or so of potential US investors, thus making the world of private placements very elite by nature. Also, the SEC has proposed new, more strict rules regarding hedge funds and accredited investors. The new rule would require that investors in hedge funds be not only accredited, but also would have to meet the requirements of the Investment Company Act section 3 (c) (7) and hold at least $2.5 million USD in investments on the date of investment. This would set an extremely high bar over which to qualify and thus theoretically protect less sophisticated investors from the significantly higher risks associated with hedge funds.

Historically, private placements in oil and gas drilling and production ventures utilized a "one third for one quarter" type investment strategy. This meant that the investment partnership organizer would draft contracts that specified that 3 investors would each put in one third of the total investment. In 2008/ 2009 investment for drilling one typical well is about $2.5 to $4.0 Million dollars. The investors each put up one third of the money but get only one fourth of the "rights" to any oil or gas found and or produced. The remaining one fourth is kept by the organizer of the investment as compensation for arranging the drilling, completion of the well, production of the oil and gas and so forth.

Investors choosing to purchase securities in the form of capital stock issued by oil and gas industry companies would be wise to understand and consider the big picture and the fact that the most lucrative oil and gas ventures are often in private placements not available to the public.

3) Purchase Securities in Publicly Traded Oil Industry Companies

Purchasing securities issued by publicly traded oil companies like Exxon Mobil (NYSE: XOM) is probably the simplest and least risk strategy to participate in the potential advantages of investing in the oil industry. Click any of the links provided to pop-up the company at our Detailed Quote Portal; and from there click the 12 Research tabs at the top for more indepth stock research.

4) Oil-Related ETFs

The commodities futures market can be a dangerous place to invest money. The margin requirements and intense daily volatility can provide excellent opportunities to profit, however can also cause huge losses. ETFs (exchange traded funds) allow you to trade the underlying commodity like a stock, without being hugely leveraged by margin. If more risk and leverage is part of a trader's game plan, try trading stock options on the ETFs. Oil-related ETFs in particular are great investment vehicles. Since the oil futures contracts always trade with such large volume and daily movement, it is easier to manage risk while still profiting from intra-day price action. Investors can get Live Oil ETF Prices and Charts for free to supplement their trading. Live price changes are crucial to the savy investors' and day traders' bottom line.

Stock investors can buy or short-sell oil-related ETFs. Two of the most traded ETFs are (NYSE: USO) and (NYSE: OIL). Also consider (AMEX: DCR), (AMEX: UCR) and (NYSE: DUG). In addition, there are two recently added double leveraged ETF's based on Crude Oil Futures rather than oil stocks, (NYSE: UCO) is ultra long crude oil and (NYSE: SCO), ulta short crude oil. These stocks are now trading at a brisk pace and are quite liquid.

However, commodity ETFs have suffered lately due to contango, which forces ETFs to suffer losses while rolling over their futures contracts (the contracts bought being more expensive than those sold). In February 2009, for instance, crude oil rose 7.4% while USO declined by 7.4%.

More at: wikinvest.com

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