The Case For Oil

The price of oil is down 16% this year. West Texas Intermediate spot prices closed the week $1 lower than last at $51.99 per barrel.

I received a lot of email from subscribers who invested heavily in oil-related stocks. They’re wondering if they blew it and should sell now to limit losses.


One way to find comfort is by comparing the behavior of oil stocks with the price of the commodity itself. The Energy Select Sector SPDR (XLE) has the following top five holdings:

23% Exxon Mobil (XOM)
13% Chevron (CVX)
09% Conoco Phillips (COP)
05% Schlumberger (SLB)
04% Occidental (OXY)

So far this year, while oil itself has dropped 16%, the Energy Select SPDR is down just 3.5%. That strong resilience is a positive sign, and probably means that crude doesn’t have much farther to fall.

Grant Prideco (GRP), the only oil stock owned by The Kelly Letter, is down 7% so far this year. That’s a reasonable slide against oil’s greater losses. Overall, we’re up 6% in Grant.

Now, think about who uses a lot of oil. Transportation stocks. There’s a handy way to see how they’re doing: monitor the Dow Jones Transportation Average, which consists of twenty stocks such as AMR Corp. (AMR), Continental Airlines (CAL), FedEx (FDX), J.B. Hunt (JBHT), JetBlue (JBLU), Ryder (R), Southwest Airlines (LUV), Union Pacific (UNP), and United Parcel Service (UPS).

If oil is truly down for the count, the Dow Transports should be on a steady run higher because their costs are coming down. Transportation investors are a smart bunch, and one of the factors they watch more closely than most people is the price of fuel, which is determined in part by the price of oil.

So, what are the transports doing? Not much. They’re up 7% to right about where they were in mid-November, testament that oil has been declining but not enough of a tear to imply a longer-term trend.

Lest memory fail you, think back to 2003 when the U.S. first invaded Iraq and there was a not-surprising victory over the Iraqi army followed by President Bush’s “Mission Accomplished” speech.

According to the Energy Information Administration, the spot price of Cushing, OK WTI dropped 22% from $35.83 in February to $28.11 in May. It averaged $30.66 in April, $30.75 in July, $31.57 in August, and touched its second bottom at $28.31 in September. From there, it embarked on its tremendous bull run to $74 last July. Even after the good news of a supposedly quick resolution to the Iraq war in 2003, oil wasted little time adjusting itself upward.

Ask yourself, “Have the geopolitical risks increased or decreased in the Middle East?” You know that higher risks in the Middle East contribute to higher oil prices. If we see rising risk in that region, it’s safe to bet on higher oil.

The U.S. just committed even more troops to Iraq. The war is widening, not wrapping up. Iran is looking more hostile toward the U.S., not friendlier. China and Russia are cooperating to lock up more of the world’s oil, not less. Those factors point to higher oil, not lower.

Banc of America investment strategist Joe Quinlan thinks that investors have “reached the point of maximum complacency” regarding the Middle East and oil prices.

Then, there are the alternative energy types who say that fossil fuels are on their way out. That’s a beautiful picture of the world and one I’d like to see in my lifetime, but it ain’t where the smart money sits.

According to the EIA’s “Annual Energy Outlook 2007 with Projections to 2030 (Early Release),” oil, coal, and natural gas will constitute the same 86% share of the total U.S. primary energy supply in 2030 that they did in 2005. From the report:

The expected rapid growth in the use of biofuels and other nonhydropower renewable energy sources begins from a very low current share of total energy use; hydroelectric power production, which accounts for the bulk of current renewable electricity supply, is nearly stagnant; and the share of total electricity supplied from nuclear power falls despite the projected new plant builds, which more than offset retirements, because the overall market for electricity continues to expand rapidly in the projection.

You can be sure that if the outlook in the enlightened U.S. is all about fossil fuels, it’s even more so in developing regions of the world.

Which brings us to an unavoidable fact. The oil story is simply this: demand is rising, supply is falling. That leads to higher prices over time.

T. Boone Pickens, one of the leading figures in the oil business, is calling for an average oil price of $70 per barrel this year.

Oil prices will rise. They might not next week, perhaps not even next month. However, the intermediate- and long-term trend is unmistakable.

Rather than selling out of fossil energy positions in this momentary downward blip, I suggest looking for places to buy in preparation for higher prices down the road.

Two that come to mind are Baker Hughes (BHI $67) for oil and BJ Services (BJS $26) for natural gas. Since last July, they’re down about 20% and 24% respectively.

Natural gas is not the focus of this report, but stocks involved in it often move in sympathy with oil stocks because weather patterns affect both. For instance, we’re seeing lower oil and natural gas prices now partly because of a warm winter. They rose on Friday, and the most commonly cited reason was that next week will be cold in Chicago and New York.

As is my way, I’d keep watching a while longer. Oil could get all the way down to $45 before real panic conditions begin peeking out. A downside risk is that energy companies will issue profit warnings and blame lower oil prices. That would send prices a leg lower and be a perfect time for bargain hunting.

Energy is not a fickle industry. It’s one of the best developed and best managed on the planet. It’s not going away. Your money invested in energy is safe. Do not sell because of currently low oil prices. They will eventually rise again.

If anything, watch the oil sector with an eye on buying.

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