Watch it Now: Why the Syrian Crisis is Far From Over
by Dr. Kent Moors, Editor, Oil & Energy Investor
The oil business is – and in our lifetimes will always be – wildly profitable. But in 2011, it will be especially so for investors.
Crude prices are about to skyrocket.
The traditional indicators have all been pointing in the same direction for some time now. Yet volatility will prove to be the key over the next year. It will also be your ticket to some hefty returns, if you know how to play it.
This instability will not treat all oil-related investments equally, of course.
But one thing is clear.
While traditional determinants will still be of some importance in estimating crude oil prices, they will no longer either control the show or be of much help in selecting the best investments.
In the past, five elements had the most direct impact on price: the value of the dollar, inventories, industrial performance as a measure of returning demand, supply constrictions, and mergers and acquisitions (M&amp;A).
Those same five factors are less indicative these days of where market is going or what participants are set to profit most from the movement. As we move into 2011, you need to offset the “tradition” with the new persistent and intensifying volatility.
Today I’m going to show you how to do that. As you’ll see, the profit potential is staggering…
The New Oil Game… and How to Win It
Despite a significant strengthening of the dollar against the euro and high inventory levels of crude oil in the U.S. market, the NYMEX West Texas Intermediate benchmark crude contract still increased 6.6% from November 17 through November 29. The London ICE Dated Brent contract increased 4.9% during the same period, reflecting the pressure on the euro and the rising value of the dollar.
Usually, however, a strengthening dollar would translate into a declining oil price, as would levels of crude surplus on the market approaching the upper end of five-year trends. And if both were to happen at the same time, as they did during mid to late November, the decline would almost always be considerable – an overreaction to both perceived “cheaper” crude (in dollar terms) and concerns over depressed demand.
Not any longer.
There will be drawbacks and consolidations. But demand is coming back into the market after a protracted period of deferral (or destruction, depending on how one looks at it) following the onset of the financial crisis. The resurgence of industrial usage, my primary thumbnail read on the true demand picture, has begun – the indication of a nascent market recovery in earnest. Six of the leading indicators, those that tend to move up in advance of a market upswing, are accelerating. And all of them are energy dependent.
The primary ingredient in the mix for the coming year, however, is the volatility factor.
Volatility, when it intensifies in a market that is trending decidedly upward, will accentuate the price hike. That is happening now and will intensify over the next year. We already see clear indications that the volatility problem is becoming more acute. In a normal market, the OIL VIX will move in the opposite direction to the pricing of oil. This is a measurement of volatility. As volatility increases, the price retreats.
Not these days…
$150 by Mid-Summer
In the last 10 trading sessions from late October to the end of November in which NYMEX prices increased by more than 1%, the OIL VIX was also positive nine times.
Given that the figure represents movement over a rolling 30-day period, this trend has a clear meaning. The pricing volatility is moving quicker (and up faster) than the OIL VIX can compensate for it.
In 2011, this will be the norm rather than the exception. Absent a collapse in the euro and a full-blown, pan-European credit crisis of major proportions (and that’s highly unlikely), the overall strength of the dollar will have less to say about oil prices than in the past. Demand will recover, and the market will move into a period highlighted by renewed concerns over adequate supply.
Volatility will merely intensify the upward pressure, because as traders find it more difficult to determine an adequate price for options on their futures contracts, the safe bet is to ratchet the price higher.
We should be looking at $100 a barrel by spring, but that figure could easily move beyond the record price of $147.27 experienced in July of 2008 by the time we reach mid-summer. That all depends on the level of returning demand and the intensification of the volatility.
There are a handful of ways to play it now, though, before prices spike.
First, the straightforward approach…
The Oil Funds
Several exchange-traded funds (ETFs) allow you to play the oil contracts without actually trading in the futures.
The U.S. Oil Fund (NYSEArca:OIL) is the best known, but the PowerShares DB Energy Index (NYSEArca:DBE) provides a way to play the differential between New York and London, between the dollar and euro base for the actual retail sale of oil products. ETFs always carry a tracking discount – which means they will not provide the entire return the underling contracts would, but are still a manageable way for the individual investor to participate in the overall rise in oil prices.
These two are also liquid enough to offset a short-term move of contracts to manipulate prices.
It is in the equity of individual companies, however, that the real moneymaking will take place.
The market is already experiencing a rising push for new production. This has resulted in rapid deployment of drilling rigs and field evaluation teams.
This is the first of three categories I want to emphasize…
The OFS Sector
Before the production hits the market, fields need to be readied, infrastructure laid down, and wells drilled and completed. This is the oil field services (OFS) sector, and it has already exhibited upward movement.
The sector is also experiencing a rapid increase in M&amp;A. That means the big are getting bigger as the market leaders continue to consolidate.
There will remain niche participants that, because of specialized expertise (especially in pressure pumping) or regional positioning, will continue to perform well. Patterson-UTI Energy Inc. (NasdaqGS:PTEN) may be the best drill-only OFS component.
Yet the moves here remain with the dominant companies – Schlumberger Ltd. (NYSE:SLB), Baker Hughes Inc. (NYSE:BHI), and Halliburton Co. (NYSE:HAL).
The level of liability Halliburton will experience because of the Macondo-1 well spill in the Gulf of Mexico, however, is still unknown.
On the production level, a rising pricing tide will not lift all boats equally. The main investment returns will not come from the largest companies but from those well-positioned, -structured, and -managed small and medium companies.
The development of the last five years has put a premium on extracting crude from fields of all sizes. However, the market leaders – the likes of Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), beleaguered BP (NYSE:BP), and ConocoPhillips (NYSE:COP) – need economy of scale to remain profitable. That means they bypass a number of fields that are simply too small for their operations.
That provides significant opportunity for a full range of U.S. and Canadian “minnows” to outperform the big boys. They’ll do it by efficiently bringing in fields with lower overhead and focused projects.
There are three things required here before making a selection: 1) previous field success and sustainable production levels; 2) access to necessary infrastructure, including pipelines and completion of all necessary field licensing and documentation; and 3) a focused and well-thought-out drilling strategy.
But there’s an easy way to play this entire group – the Wildcatters Exploration &amp; Production Equity Fund (NYSEArca:WCAT), an ETF that highlights these small- and medium-sized producers.
Finally, in what is certainly going to be the most expansive development, 2011 will bring a further move from conventional to unconventional production in both natural gas and oil.
The gas revolution is shale gas, and the companies leading the way in the Marcellus, Fayetteville, Eagle Ford, and dozens of other up-and-coming basins will have a greater impact in the energy mix moving forward.
However, the unconventional in oil plays will also emerge as a major driver.
As supply concerns intensify, oil shale, heavy oil, bitumen, and especially Canadian oil sands will occupy a more important position. These are more expensive to produce, and there are environmental concerns to overcome, but North America will progressively turn to such sources as the traditional conventional crude sources continue to decline. So stay tuned.
Next year will require that the investor view the market in ways distinct from the recent past. The combination of volatility and movements into new sourcing will result in uncertainty. But with a balanced approach of ETFs and individual company shares, we will weather the storm.
Make no mistake: There is a great deal of oil money to be made in 2011.
For 31 years, Dr. Kent Moors has been advising the world’s largest and most active energy producers and buyers – including six of the world’s top 10 oil companies, leading natural gas producers and high-level government officials from the U.S., Canada, Russia, Kazakhstan, the Bahamas, Iraq, and Kurdistan. When Kent’s not busy making the news in the energy sector, he follows the latest developments in his free E-letter, Oil &amp; Energy Investor. He also edits Energy Advantage, a monthly newsletter designed to capture long-term profits in the energy markets. His brand-new service, the Energy Inner Circle, is for investors looking to benefit from unique access to Kent’s powerful network of industry contacts. For more information, call our VIP Services group at 888.570.9830 or 410.454.0498.