Back in calmer times, in January or February of this year, there was a lot of talk about how global economic growth—both in the U.S. and other developed countries—and in the fast-paced developing world, notably China and India, would bump up against available oil supply, leading to a rising price for crude.
With oil at that time selling around $80 per barrel, analysts were talking about prices rising to over the $100 level, with outliers mentioning $115 or $120 per barrel, making oil look like a good investment bet.
Then came the tsunamis.
First it was a political tsunami, which started in Tunis, the capital of Tunisia in North Africa. A fruit-seller, humiliated by an officer in the bureaucracy of a hated dictator, self-immolated and ignited a popular uprising that toppled the government of Zine el Abidine Ben Ali, leading in short order to another, bigger popular uprising in Egypt, which pushed the 30-year dictator, Hosni Mubarak, from power. That tsunami of human aspiration has continued to spread, to Libya, Yemen, Bahrain, Syria and Saudi Arabia.
Then came an earthquake and an actual tsunami in Japan, which beside killing some 18,000 people at press time, caused a meltdown at the Tokyo Electric Power Co.'s nuclear complex at Fukushima. This has thrown a "nuclear renaissance" in the U.S., Europe and China into question.
So what does all this mean for investing in oil, a commodity that has shown an extraordinary amount of volatility in recent years?
Christian Hviid, chief market strategist with Genworth Financial Asset Management summarizes the short- and long-term views this way: "Short term, you've got a 15% to 20% risk premium built in because of the political situation in the Middle East. Then with the likely temporary shutdown of many older nuclear reactors because of concerns about what is happening in Japan, you're going to see higher prices for especially LNG [liquid natural gas] but also oil," says Hviid. "But longer term, you've got supply constraints. China, remember, is now the largest market for cars, and that demand will only continue to grow. Demand will also grow for oil as economies recover. Meanwhile, we're entering an era of a kind of cold war for resources, including oil. So I'm bullish on oil. I'm bullish on commodities in general as a play on a weakening U.S. dollar." (Oil is priced in dollars, so that as the dollar falls in value against other currencies, the price of oil in dollars rises.)
Hviid warns that investing in oil should not be speculative, but rather a long-term strategy for most investors. "Over the next year, there is going to be a lot of volatility in oil prices," he cautions. "You could see things go either way. If the political situation in the Middle East calms down over the year, we could see oil prices go down significantly." But if things continue as they are, or even heat up in other producing countries, prices could rise dramatically.
Nomura Securities analyst Michael Lo, in Hong Kong, notes than during the first Gulf War against Iraq, in 1991, oil prices jumped 170%. He notes that with spare production capacity, particularly in Saudi Arabia, currently estimated at 2.1 million barrels of oil a day, a halt in oil shipments from just mid-range producers—such as Libya and Algeria, or larger producers, such as Bahrain or the United Arab Emirates (UAE)—could wipe that surplus out, and push oil prices up rapidly to anywhere from $175 a barrel to as much as $220 a barrel. Lo says that the Saudis may have been deliberately overstating the actual size of their Âreserves and their ability to pump out more oil in a crisis.
A WikiLeaks cable recently suggested that this was the case. "If it turns out that WikiLeaks is right, then $220-a-barrel oil would be just the beginning," says Lo. He is not alone. Alan Duncan, an oil trader with 30 years' experience, was quoted in The London Times recently saying that if Saudi Arabia or another major oil producer's wells or port facilities were bombed during political unrest, oil could jump to $250 a barrel.
Libya produces some 1.6 million barrels of oil a day when the country's wells and pipelines are running at full tilt (which they aren't right now). In contrast, Iran, which has already had one major popular uprising, produces 4.1 million barrels a day. Iraq, which is plagued with daily bombings, including strikes at oil facilities, produces 2.7 million barrels a day. The UAE produces 3.7 million barrels, while Venezuela and Kuwait produce 2.7 and 2.6 million, respectively. Saudi Arabia, the megaproducer, pumps 10.2 million barrels a day. Given that the demand for political change across the Middle East is unlikely to fade away quickly, and the nuclear crisis in Japan—even if it is resolved soon, will likely require the shutdown, inspection and upgrading for months or even longer, of many creaky nuclear reactors—oil prices are likely to remain high and even rise in the short to middle term. And with economic growth increasing demand for oil, and available supply unlikely to grow, the longer-term picture appears bullish. "We don't see oil prices or volatility cooling down anytime soon," says Lysle Brinker, an analyst with IHS Herold.
Even without the global turmoil, many oil industry analysts are saying that just the secular supply-and- demand situation alone would suggest that oil prices over the long haul have a ways to rise. "We have been having a luxury situation for a while, with oil selling in the $70 to $90 price range," says Standard & Poor's analyst Stuart Glickman. That outlook, based on research from Global Insight, projected oil reaching $95 a barrel by 2012. But that was before the upheaval in the Middle East and the nuclear crisis in Japan. Now, says Glickman, "to say that oil won't top $105 is ridiculous."
To think that oil won't hit those highs, he says, you'd have to believe that the geopolitical situation for oil couldn't get worse. "I don't think we can say that because there are much bigger oil producers than Libya that have serious democratic issues."
S&P's Glickman says that since most investors don't have the assets or risk appetite to invest in oil futures contracts, the best bet for bank clients would be to invest in pure-play exploration and production companies like Apache Corp. (APA) or Anadarko Petroleum Corp. (APC). A low-cost alternative would be an ETF like iShares Dow Energy ETF (IYE), which holds companies such as Exxon, Chevron, Conoco, Oxidental, Anadarko and Haliburton. "We're overweighted on IYE," he says, noting that it is 98.5% energy focused, primarily on oil."
Another way to play oil, he says, is to go for a broader commodity ETF, like the iShares Dow Jones Basic Materials ETF (IYM), which is 87% materials and 10% energy.
New natural gas supplies coming online shouldn't dirty the oil picture. Analysts suggest that with a major nuclear power pullback over the next year, and perhaps longer, natural gas will be in demand as fuel for conventional electric power plants. But Lo says that the likely boom in liquefied natural gas would have a knock-out impact on oil prices because generally LNG and oil prices move in tandem. "It's difficult to say" exactly how increased LNG demand will impact oil prices, he says, but using more LNG for electric power generation should "prove positive for oil."